A credit score is a numerical score assigned to an individual to represent how creditworthy they are. Credit scores range from 300 (very low) to 850 (very high), and higher credit scores are most desirable. A high credit score, which is a function of several factors, will help a borrower get approved for a mortgage or a credit card because it shows a bank (or other lender) that the borrower has a long track record of paying back their debts.
Who decides credit scores?
Credit scores are calculated by 3 independent agencies: Equifax, Experian, and TransUnion. These three agencies receive information from banks, credit unions, utility companies, and other entities about individuals with Social Security Numbers. These credit reporting agencies use proprietary statistical analyses (i.e. they do not release the exact methodology) to assign a number to someone’s borrowing history.
What factors impact a credit score?
While there are many factors that credit reporting agencies utilize, the most important are the following:
- Credit History: Lenders want to know whether a prospective borrower has a long track record of paying back their debts. Accordingly, credit score calculations heavily take into account whether the individual has missed any payments (e.g. did not pay their mortgage one month, did not pay their full credit card balance, etc.) and how recently that occurred.
- Credit utilization: If a borrower has 5 credit cards and spends them each to their full limit each month, that may scare away some potential lenders. Banks prefer to see prospective borrowers use a low percent of their available credit each month.
- Types of credit accounts used: The scoring algorithms give preference to individuals with a mix of different credit types. Multiple types of credit include credit cards, mortgage, car loans, student loans, and more.
- Length of credit history: Lenders want to see that you have experience properly handling your money. If you have had open credit accounts for several years, that gives lenders confidence that you know what you’re doing. If you just opened your first credit card last month, another bank might be hesitant to issue you another credit card.
- Recent requests for credit: When you apply for a credit card or other loan, the lender will triggNer a “hard pull” of your credit report. This can be a negative, and is a way for credit rating agencies to notify lenders if you have been going to all the other banks in town to ask for a loan.
How do you improve your credit? How long does it take?
Improving your credit is simple: pay your debts in full, on time, and continuously. This is called building your credit history. If you just start paying your credit card balance in full and do not miss any payments, your score will start going up.
Things that will hurt your credit score are things to be avoided: missing payments, carrying balances, opening lots of new accounts, and applying for loans or credit cards that you do not receive.
The process of building your credit score can take months or years, but that is the purpose of a credit score. If you can diligently pay your bills, live within your means, and manage your money responsibly for several years, banks will be more likely to trust you if you ask to borrow some money.
