Credit Scores
If you have applied recently for a mortgage, auto loan, or new credit card, you probably were reminded of an important personal financial metric – your credit score. A credit score is a numerical expression of the creditworthiness of an individual and is used primarily by lenders to evaluate the likelihood of being repaid by a borrower. Credit scores range from 300-850 and those above 700 are generally considered “good” while those over 780 are considered the top tier. The stronger your score, the more attractive your borrowing terms, potentially saving you thousands of dollars in interest.
While there are numerous variables that go into credit score calculations, some are more important than others.
On-time payments
Perhaps most important is paying your bills on time. Indeed, it is better for your credit score to pay on time at least the minimum amount required than it is to pay your balance in full after the minimum payment due date.
Length of history
Credit scores are also positively impacted by the length of credit history. Somewhat surprisingly, currently it is better to leave open a credit card that you have maintained for a long time but no longer use than it is to close it since doing so shortens your credit history.
Percent of credit used
Your use of credit also impacts your score with lower usage being better than higher usage even if the amounts of use are dramatically different. For example, a credit card with $1,000 of availability that has $900 outstanding negatively impacts a credit score more than one with $50,000 of availability and $10,000 outstanding because the former is 90% utilized while the latter is only 20% utilized.
Credit inquiries
Finally, credit scores are impaired when too many lenders check your credit. These are referred to as “hard inquiry” or “hard hit” credit checks and too many of them reduce your score. Note, however, that you checking your own credit does not constitute a “hard hit.”
If it seems as though some of the measures used to calculate your credit score are illogical or, at least, antiquated, it is because they are. With the advent of “big data” however, ratings agencies are developing better methods of evaluating a borrower’s credit worthiness and changes to score calculations are coming. Notably, maintaining old cards that you no longer use may soon hurt your score rather than help it. And, more sensibly, credit ratings agencies will soon begin taking into account the trajectory of a borrower’s debts on a month-to-month basis. Borrowers with declining debts will be rewarded with higher scores while those with increasing debts will receive lower scores.
The importance of credit scores requires that you understand how they are calculated so you can ensure that your credit activities positively impact your score. Pay attention to changes in the calculations since techniques that currently enhance your score soon may hurt it.
Don’t know your credit score? You can get it online at www.creditkarma.com or www.annualcreditreport.com . Annually you can review your credit report for free from each of the three credit bureaus. For a minimal price, they will also tell you your credit score.
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