Credit scores affect your life in many important ways. First, anytime you apply for a mortgage, car loan, credit card, or financing of any kind your credit score will be looked at to determine whether you are approved or denied financing. If you are approved, your credit scores are looked at again to determine what kind of interest rate you will receive. Credit scores are the #1 factor considered when you apply for a loan.
Since credit scores are the first key to loan approval, let’s talk a little about where these credit scores come from and how they are calculated. There are 3 major credit bureaus in the United States: Equifax, Trans Union, and Experian. Typically, each credit bureau will give you a different score. The following chart shows the basic makeup of a credit score with any of the 3 major credit bureaus:
Payment History, an individual’s history of paying bills on time, accounts for 35% of your credit score. If a person has a high percentage of late payments on bills then his/her credit score will be lower. It may sound crazy, but late payments can lower a person’s credit scores more than any other factor including bankruptcy, foreclosure, or repossession! One late payment can actually drop someone’s credit score 30-100 points (especially if it is the first time a late payment is appearing on the credit report in a while).
Amounts Owed account for 30% of your credit score. This factor can sometimes be a little confusing. The credit bureaus will look at the amount of debt being carried by a person and compare it to that person’s available credit limit. For example, if you have a credit card with a $500 limit and you owe $490 on the card then your credit score will be lowered. However, keep that same credit card paid off and your credit score will receive a boost! High credit card balances can significantly lower your credit score, even if you pay your monthly bill on time!
Length of Credit History makes up 15% of our credit score. The credit bureaus look at the age of a person’s open credit lines to determine how many points will be awarded or taken away from the credit score for this category. The older the accounts appearing on your credit report, the better. Opening a new account can potentially lower your credit score even if you have never missed a payment on the account – so proceed with caution when applying for new credit.
New Credit makes up 10% of your credit score. This refers to how often a person applies for new accounts. Every time your credit report is pulled to apply for a loan your score is typically lowered 1-3 points and you do not regain those lost points for at least 90 days. However, a “soft pull” of your credit report (that is an individual requesting a copy of his/her own personal credit report to review the file) does not hurt your credit score at all. If you have not reviewed your credit report in a while, you are entitled to a free copy every year from www.annualcreditreport.com. Checking your report at least once a year for errors is highly recommended.
Types of Credit Used account for the final 10% of your credit score. It is important to have the right balance of accounts on your credit report. Too many accounts can hurt your credit scores, but so can too few accounts. Also, loans with consumer finance companies (i.e. paycheck advance loans) will hurt your credit scores just by opening the account and should be avoided.