The importance of credit scores is a topic that has grown increasingly important since the beginning of the credit crisis. What score is good enough to be credit-worthy?
Your credit score, also known as your FICO score, is a large determinant of the types of credit you have access to, and at what rates. According to CNN Money, someone with a score of 580 will likely pay 3 more percentage points on a mortgage than someone with a 720--and with currently strict standards, a score in the 500s may make it difficult to qualify at all.
Generally, scores above 720 are considered "excellent," but each lender has its own scale. Scores in the high 600s to low 700s will qualify you for most credit cards and loans, but not at the very best interest rates. Scores below the mid-600s will begin to detrimentally affect your ability to get credit cards and loans, at least with attractive rates. Now more than ever, creditors seek customers with excellent track records for their best offers.
So, how exactly is your score calculated, and what can you do to improve it?
1. Payment history (35%)
Do you pay all of your bills, and pay them on time? This part of your score--the largest component--is based on the number of payments past due, how far past due they were, and how recently late payments occurred. This section also includes bankruptcies, liens, collection items, and so on.
2. Amounts owed (30%)
This section looks at how much you owe, the number of accounts with balances, and how much of your available credit you are using--also known as your "credit utilization ratio" or "debt-to-credit ratio." You want some debt to show that you can handle credit responsibly, but try to keep your debt under 30% of your total credit.
Be aware that your debt-to-credit ratio can increase even if you are not spending more--card issuers have been reducing lines of credit even for customers whose spending habits have not changed and who have not had any late payments. If you fall into this group, it's worth calling your card-issuer to try to have the reduction reversed.
3. Length of your credit history (15%)
As you'd expect, this takes into account how long you have had credit. The time since accounts were opened and since they were last used are both factors. Given this, it is important that you do not close your oldest accounts, especially if you have a relatively short credit history. Beyond reducing your available credit, closing your older accounts could make your credit history appear shorter. If you have a relatively long credit history (more than 10 years or so), don't worry too much about closing one or two accounts, so long as you have others from the same period.
4. New credit (10%)
This looks at the proportion of accounts that were recently opened and the number and recency of new credit inquiries. Inquiries occur when you apply for a credit card, car loan, or other line of credit and the originator requests your credit score. For mortgages, car loans, and student loans, multiple inquiries within a short period of time (usually 14 to 30 days) are considered acceptable "rate shopping" and are treated as a single inquiry, so you do not have to worry that checking with multiple lenders will have a negative impact on your score. Only inquiries that you initiate by applying for new credit count against your score--checking your own score will not count against you. Promotional inquiries for pre-approved credit cards and the like are excluded, as are requests from employers. Opening new accounts over time helps your score, but it can hurt to open too many accounts within a short period--as you risk looking desperate for credit.
5. Types of Credit (10%)
This looks at the variety of your credit lines. Having a healthy mix of different types of credit--such as credit cards, a car loan, and a mortgage--improves your score, as long as you stay current on all of your accounts.
Your credit score does not factor in your employment status, income, age, gender, or other noncredit-related information.
Steps to Improving Your Score
Knowing the factors that go into your score makes it easy to identify areas to improve. Start with the most heavily weighted areas: payment history and amounts owed.
1. Check your credit report at least once each year. This will not only help show you where you stand, but will also help you identify unauthorized accounts. Quickly dispute inaccurate information or accounts that are not yours. You are legally entitled to a free report annually from each of the three major providers--Experian, TransUnion and Equifax (EFX).
It is normal for your score to vary slightly between the three reports. Space out your requests from each so that you can see a new report every 4 months. Annualcreditreport.com is the official site to access your free annual credit report. Another useful, free resource for credit information is CreditKarma.com.
Be vigilant when accessing your reports online, as some Web sites offer a portal to download your free reports in conjunction with enrollment in continued credit services for which they will charge you if you do not opt out.
And remember, checking your score will not hurt your credit--only inquiries from potential new credit sources will impact your score.
2. Re-establish on-time payments. The longer your history of on-time payments and the further you get from missed payments, the better your score will be. Opening a new account and paying it off consistently will eventually raise your score. Items such as bankruptcies affect your score for seven years, but you can start minimizing the damage after two years of on-time payments.
3. Keep your balance low as a proportion of your total available credit. Do not cancel accounts you no longer use, because doing so would decrease your available credit and thus increase your credit utilization ratio. Similarly, you should not voluntarily reduce your credit limit. That said, you also should not open a lot of accounts solely to increase your available credit. Such a strategy could backfire, as a flurry of new credit applications will increase the number of inquiries and lower the average age of your accounts, hurting your score. If you have unused accounts that are charging high annual fees, consider closing them. Even if you are no longer using certain accounts, it's important to keep an eye on them to protect yourself against fraudulent use.
4. If you want to close multiple accounts, space them out rather than closing them all at once. Same goes for applying for multiple credit cards.
5. Keep your rate-shopping period for home and car loans to within 30 days to ensure your comparisons are treated as only one inquiry.