What Makes up a Credit Score (and why does it matter)?

Credit is an important part of our financial lives. While it is most important to live within your means and not overextend yourself, some things are necessarily bought over time, such as residences or cars. Other reasons to use credit (wisely) are to take advantage of cash back deals, air miles or other rewards that come with the cards.

By now, most consumers and business owners know that having good credit is key to financial stability. If your score is low, you may have difficulty obtaining credit or pay higher interest rates whenever you need to borrow money for a house or car, or get a loan or credit card. Credit can also affect everything from the ability to rent to job security. Employers, lenders and even auto insurers look at credit reports before they will extend offers. That’s why it’s so important to fully understand what goes into making a credit score, so that you can stay on top of it and ensure you have the highest score possible.

There are several different credit agencies, and they all score slightly differently, but they have a few major factors in common. FICO is the agency most banks turn to. FICO scores range from 300 to 850. Here’s a breakdown of what goes into a FICO credit score.

Payment history – The most important factor of a FICO credit score is payment history. It makes up a whopping 35 percent of your score. This means it’s critical to make payments on time as much as possible. FICO assess both kinds of debt on your credit report. Revolving debt is debt from things like credit cards or equity lines of credit – you pay it down and charge it back up. Installment loans are made up of a fixed amount of money that you borrow and eventually pay off, like a mortgage, car payment or student loan. The various kinds of debt are weighted differently, but it will hurt your score much more if you default on a large installment loan like a mortgage rather than a small, revolving debt like a low-balance credit card. Consistently making timely payments is the number one best way to improve your score.

Credit utilization – The second most important factor of your FICO score is the percentage of your available credit that has been borrowed. This makes up 30 percent of your FICO score. Ideally, you want to have about 7 percent credit utilization, according to FICO, as the people with the highest credit scores are in this range. However, if you can get between 10 and 20 percent utilization, that’s still going to give you a decent score. The lesson here is not to carry large balances on your credit if you want to have a good FICO score.

Length of credit history – Time makes up another healthy sized chunk of your total credit score, weighing in at 15 percent of your total score. FICO measures the length of time each account has been open and the length of time since there was any activity on the account. This makes it impossible for someone just starting to build a credit history to have a perfect store. Don’t worry though, because over time you will be able to build your score by maintaining long-standing accounts, paying on time and keeping low balances.

New Credit – Even if you’re just starting to establish credit, opening too many credit lines at once can hurt your score. FICO suggests only taking on new credit when it’s financially necessary. If you borrow a lot of money at once, they look at this as though you are in a financial bind.

Credit mix – The final factor FICO measures is the mixture of revolving debt and installment loans. Having a good mixture of both shows you can responsibly handle any kind of payment and reflects positively in your score.

It’s also important to review your credit report regularly to be sure that it is accurate. Regular review can also provide early identification of fraudulent use of your credit. Credit reporting agencies are required by law to provide one free credit report per year. These agencies are Transunion, Experian and Equifax. One way to access these reports at no charge is using www.annualcreditreport.com. If you find errors in your credit report, the agencies are required to review and list corrections. Unfortunately, in this area you are guilty until proven innocent. But be persistent because it does affect your ability to obtain credit at the rate you are entitled to.

What it comes down to is this. Good credit takes a while to build. So when credit is involved, make sure the decisions you make are the best ones. Be responsible, be timely and be informed. Take credit seriously so you can have a firm foundation on which to build your financial future.

Wood Smith Advisors, a Registered Investment Advisor (RIA), is a fee-only financial services firm that partners with its clients to simplify their financial lives. We focus on women, entrepreneurs and individuals with complex financial situations, providing objective and competent advice, education and services to help them develop and build their businesses and reach their financial goals. We can be reached by clicking here.

“Finance Made Simple” blog posts are intended for educational purposes and not for specific advice.  Each person’s situation is different.  Consult your financial advisor for advice relating to topics discussed.

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