Understand How Your Credit Score is Calculated

Before making a big purchase like a home, refinancing or investing in real estate, it’s incredibly important to understand your credit score and what factors go into making it. With the proper knowledge, you can improve your credit score and, in the process, save thousands of dollars over time by reducing your mortgage interest rate. While this article is for homebuyers and borrowers in Solano County, it’s really applicable to anyone.

This post is for informational and educational purposes only. It is not legal or financial advice. We are not attorneys or financial advisors.

What is a Credit Score

A credit score is a numerical representation, typically ranging from 300 to 850, that reflects an individual’s creditworthiness based on their credit history and financial behavior.

Derived from the data in one’s credit report, this score is formulated using a variety of factors including payment history, amounts owed, length of credit history, new credit, and the types of credit used. The score serves as a predictive indicator for lenders, providing a quick snapshot of the potential risk involved when lending money or providing credit to an individual.

A higher score generally indicates that the individual has been responsible with their credit obligations in the past, implying lower risk for lenders, while a lower score suggests the opposite, signaling potential credit risk.

As a result, one’s credit score can significantly influence the terms, interest rates, and approval of loans or credit cards. In essence, it’s a tool that allows financial institutions to assess how likely an individual is to repay borrowed money.

What Factors Affect Your Credit Score

In order to understand and eventually improve your credit score, we first must understand what factors are used to calculate it. Here’s what they are and what weight is applied to each factor.

Payment History (35%)

Payment history, as it pertains to your credit score, refers to the record of your payments on various credit accounts, such as credit cards, mortgages, and other loans. It demonstrates your reliability in fulfilling your financial obligations over time.

This factor is crucial, often accounting for approximately 35% of your total credit score, making it the single most significant component. Consistent on-time payments positively influence your credit score, showcasing your responsibility and reducing risk for lenders.

Conversely, late payments, defaults, or other negative markers can significantly lower your score, indicating potential credit risk.

Amount Owed (30%)

Amount owed refers to the total sum of money you owe to lenders across various credit accounts, such as credit cards, mortgages, and other loans.

However, it’s not just the absolute amount that matters; the credit utilization ratio plays a crucial role too. This ratio is determined by comparing the amount of credit you’re currently using to your available credit limits. For instance, if you have a credit card with a $10,000 limit and you’ve used $3,000, your credit utilization for that card is 30%.

Amount owed and credit utilization collectively contribute to roughly 30% of your credit score. Maintaining a low credit utilization rate indicates to lenders that you manage your credit responsibly and don’t overextend yourself financially, positively influencing your credit score. Conversely, high utilization can be seen as risky, potentially lowering your score.

Length of Credit History (15%)

Length of credit history represents the duration of time your credit accounts have been active. This encompasses the age of your oldest account, the age of your newest account, and an average age of all your accounts.

Contributing to approximately 15% of your overall credit score, this factor offers lenders insights into your long-term financial behavior. A longer credit history, especially one with consistent positive payment patterns, is typically viewed favorably as it provides a more comprehensive record of a borrower’s financial habits.

Conversely, a shorter credit history may not offer lenders enough information to determine creditworthiness, potentially making it harder for individuals to secure favorable credit terms or even get approved for new credit.

New Credit (10%)

The term “new credit,” in the context of your credit score, refers to any recently opened credit accounts or recent inquiries into your credit by potential lenders. This includes new credit cards, mortgages, car loans, or other lines of credit you’ve recently taken on.

Representing approximately 10% of your overall credit score, the new credit factor is based on the premise that opening several new credit accounts in a short period indicates higher risk, especially if one’s credit history is relatively young. Every time you apply for credit, a “hard inquiry” is made on your credit report, and multiple such inquiries in a short span can temporarily lower your credit score.

The rationale behind this is that individuals who open multiple accounts in a short time might be facing financial strain or may not be able to handle their new credit responsibilities. However, the impact of new credit on your score diminishes over time, especially if the new accounts are managed responsibly.

Credit Mix (10%)

Credit mix refers to the variety of credit accounts an individual has, encompassing different types of credit products such as credit cards, mortgages, installment loans, retail accounts, and auto loans.

Making up about 10% of your overall credit score, credit mix offers potential lenders a more holistic view of how you manage diverse credit responsibilities. A well-rounded mix indicates to lenders that you can handle various credit structures responsibly.

For instance, having experience with both revolving credit (like credit cards) and installment loans (like a mortgage or auto loan) can be favorable for your score. However, it’s essential to note that while a diverse credit mix can enhance your score, it’s not advisable to open credit accounts unnecessarily, as each carries its own responsibilities and potential pitfalls.

It’s always best to acquire and use credit based on genuine need and financial planning rather than just to diversify one’s credit portfolio.

What You Can Do to Improve Your Credit Score

Pay Bills On Time

  • Late payments, even by a few days, can significantly affect your credit score.
  • Set up reminders or automatic payments to ensure you never miss a due date.

Regularly Check Your Credit Reports

  • Obtain your free annual credit reports from the three main credit bureaus: Equifax, Experian, and TransUnion.
  • Review them for inaccuracies. Errors, such as wrongly listed late payments or unauthorized accounts, can detrimentally impact your score.

Quickly Fix Errors in Your Credit Report

  • If discrepancies are found, file a dispute with the respective credit bureau.
  • Supply any corroborating documentation to substantiate your claim.

Reduce Credit Utilization

  • Aim for a credit utilization ratio below 30%. For instance, if you have a credit limit of $10,000, try to maintain a balance below $3,000.
  • Consider paying your credit card balances multiple times a month to keep the utilization ratio low.

Avoid Closing Old Credit Cards

  • An older credit history can favorably influence your score.
  • Closing a credit card can also reduce your available credit, elevating your credit utilization ratio.

Limit Hard Inquiries

  • Every time you apply for credit, a hard inquiry is posted to your report, which can drop your score by a few points.
  • While the impact of hard inquiries diminishes over time, it’s wise to only apply for new credit when necessary.

Diversify Your Credit Mix

  • Responsibly managing various types of credit, such as a mortgage, auto loan, and credit cards, can boost your score.
  • However, only open the types of accounts you genuinely need.

Negotiate with Creditors

  • If you’ve missed payments, it’s not too late to negotiate. Some creditors might agree to an “account paid in full” status rather than reporting the account as “settled.”
  • Consider writing a goodwill letter asking the creditor to remove the late payment from your credit report.

Consider Becoming an Authorized User

  • Being added to a responsible payer’s credit card account can improve your credit score.
  • Ensure that the account holder maintains low balances and pays punctually.

Tackle Outstanding Debts

Create a strategy to pay down existing debts. Whether it’s the snowball method (smallest debts first) or avalanche method (highest interest first), choose a method suitable for your circumstances.

Avoid Predatory Loans and Services

  • Be wary of services promising to “fix” or “repair” your credit for a hefty fee. Often, they’re scams.
  • Avoid payday loans or any high-interest loans that can trap you in a cycle of debt.

Talk to a Professional

If you’re struggling, consider contacting a credit counseling agency. They can offer advice and even negotiate with creditors on your behalf. The fee paid to a credit counseling service may be very small compared to the interest you’re paying on current and future debt.

In Conclusion

Building or rebuilding a credit score is a marathon, not a sprint. By consistently making sound financial decisions and monitoring your credit, you’ll pave the path to a robust credit score and the myriad of benefits it brings.

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