Understanding Your Credit Score

Your credit score is a three digit number, ranging from 300 to 850. If you have a credit card, loan, mortgage, cell phone contract, car insurance, or any other type of regular bill, you will have a credit score. Keeping your score high is the single most important thing you can do in the world of personal finance, because it dictates how likely you are to receive good deals in the future.

Credit Score Calculation

Your score is calculated by a company called FICO, and is worked out by the differential weighting of 5 aspects of your financial history. These are:

  1. Payment History (accounting for 35%)
  2. Available Credit (30%)
  3. Length of Credit History (15%)
  4. New Credit (10%)
  5. Type of Credit (10%)

Payment History

Your payment history, quite simply, refers to how reliably you have paid your bills on time each month. If you have late payments or missed payments, you will have damaged this aspect of your score.

This also takes into account how much you currently owe and how long you have been in debt. This is why it is a good idea to pay your charges in full each month. If you find that you are unable to pay your bills in full each month, focus on paying off your longest standing charges first.

Negative aspects of your payment history stay on your record for about 7 years, so if you have worrisome activity within the past 7 years, this will hurt your score.

Available Credit

Available credit refers to how much of your monthly limit you have used (also referred to as credit utilization). If you tend to reach your monthly limit often, this will hurt your credit score.

Generally, it is most beneficial to keep your credit utilization within 30% of your credit limit. So, if your monthly limit is $2,000, aim to charges no more than $600 to your account each month. This will demonstrate to lenders and creditors that you have a lot of unused available credit, which will show that you are a responsible borrower.

If you have multiple cards, your total available credit will be calculated from adding all of your limits together. Luckily, even if you spend a lot, you can keep your credit utilization low by spreading your charges across your accounts.

If your limit is quite low and you find that you usually spend more than 50% of it each month, ask for an increase. This will keep your utilization low because even if you spend the same amount, it will be a smaller percentage of your available credit. Alternatively, if you spend more than usual on one particular month, try to pay it off before your bill arrives.

Length of Credit History

The length of credit history pertains to how long you can demonstrate that you are reliable. How many years have you been paying your phone bill, car insurance, or credit bill? You are considered more reliable and worthy of a loan or mortgage if you can demonstrate that you have maintained a good history for 20 years, whereas you will be less trustworthy if you have only six months of history.

Length of history is important because you can show lenders that you have been reliably paying your bills for years, but accounts for a much smaller portion to ensure that potentially reliable new borrowers are not unfairly disadvantaged.

To keep the length of your credit history as long as possible, do not close your longest standing accounts, even if you no longer use them. They contribute to the age of your credit history. Closing accounts will not remove them from your report immediately; they will remain on your account for the next 7-10 years.

If you have a good history associated with your very first account, do not close it because in 10 years, it will no longer help your credit score. If you have a bad history associated with your first account, you could consider closing it so that it is removed from your report in 7 years, but weigh up the pros and cons of whether it is worth it to shave years off your history.

New Credit

New credit refers to how likely you are to open new accounts. This demonstrates to lenders and creditors that you might not be financially stable; if you regularly apply for new cards or new mortgages, you may have a shortage of money.

Your score will be lowered by a few points every time you open a new card account, but in the grand scheme of things this does not damage your score much if you keep this behavior moderate. Opening one new account every year is reasonable, whilst opening 3 new accounts every couple of months indicates a need for money.

Type of Credit

Basically, there are two main types. The first is installment credit, such as loans or mortgages, in which you pay off a large sum over a series of small installments. The second is revolving accounts, such as credit cards or cell phone contracts, in which you are free to use a certain amount each month as long as you pay your bill.

Aim for a diverse variety of both types of credit because this shows that you are reliable and experienced in each area. However, you should not open accounts solely to boost your score.

Conclusion

A score of at least 700 is considered to be quite good, but if you are thinking of getting a mortgage or multiple cards, you should aim for at least 750 to ensure that you will benefit from low interest rates.