“Credit” is used so many ways to define so many things that whoever was the first to use credit to refer to your “credit score” needs a slap in the face with a thesaurus.
So for our purposes when you see “credit”, think “credit score”.
K so what is credit? A common questions in the millennial handbook. What is credit and why is it important? Which is usually followed up with “how can I increase my score or what’s hurting my score?”
The simple answer is that your credit score will determine a lot in life. Your credit score is how banks, credit card companies, and just about anyone else in the real world decides whether or not you’re a responsible money person.
Think of it as a way the world tracks your financial health. The higher the score the better off you are, and the more likely you’ll get favorable terms when borrowing money.
Usually, a credit score above 700 is considered good.
The higher your score the more likely when comes time to apply for a loan or credit card you’ll 1) get accepted 2) be able to ask for a larger amount and 3) have to pay less interest on that loan.
Here’s a quick example:
Let’s say two people both want a 1 year $1,000 loan. Applicant A has a credit score of 500 and B has a credit score of 700. As a lender I would see the better score and assume that applicant B is more reliable and able to meet their interest payments on time so I’ll charge them less interest. I’ll charge applicant B only 4% interest and applicant A 6% interest.
Seems like a minor difference but lets do some quick overly simplified math. 6% x $1,000 = $60 vs. 4% x $1,000= $40. That’s a $20 difference. Seems small, but what if the loan was $10,000 instead? Applicant A now has to pay $600, where as applicant B pays $400. Again, this is grossly simplified but hopefully makes it clear. Applicant A has to pay $200 extra just because they weren’t considering (or didn’t know) what was hurting their score.
Whats that mean for you?
As your financials change, so does your score, knowing what factors affect your credit score gives you the opportunity to improve it over time.
The Most Common Factors That Affect Your Score
Payment History. Payment history is the most important ingredient in credit scoring, and even one missed payment can have a negative impact on your score. Lenders want to be sure that you will pay back your debt (not just the minimum due) and on time.
Credit Utilization. Your credit utilization is based on how much of your TOTAL credit you’re using at any given time. This ratio looks at how much of your available credit you’re utilizing and can give a snapshot of how reliant you are on your credit cards/loans.
Credit Mix. People with top credit scores often carry a diverse portfolio of credit accounts. Lenders use this credit mix to understand past debt experiences and how you have handled them.
Hard Inquiries. Hard inquiries are recorded in your credit file each time a lender requests your credit report as part of their decision-making process. Usually, happens when you apply for a credit card or a mortgage. Checking your credit score through apps or your bank is a soft inquiry and doesn’t affect your score.
Negative Information. Late or missed payments, foreclosures, collection accounts are all examples of negative information that can appear in your credit file. These typically indicate that you have defaulted on a loan in the past or missed a payment and can be red flags. These records typically stay in your file for at least seven years, so it’s best to avoid any negative infraction if at all possible.
How do I increase my credit score?
Stay On Top Of Your Payments. I cannot stress this enough. This is the easiest to mess up and the number one way to increase your credit. Showing that you have a reliable repayment history tells lenders you are responsible and is a good indicator you’ll handle future debts responsibly as well.
Keep Your Outstanding Debt Low. Credit utilization is a way to see how much of you’re outstanding credit you still have available. “Maxing” out your credit cards will ultimately hurt your credit because it will be viewed as having too much risk. Pay off that debt as quickly as possible.
Monitor Your Credit. There are a lot of great resources to use to monitor your credit. If you file through turbo tax, they offer a credit monitoring report for free. Most banks today as well as credit card companies will also offer free credit reporting. Monitoring your score’s fluctuations every few months can help you understand how well you’re managing your credit and whether you should make any changes.
Finally, Be Patient. Building great credit won’t happen over night. The old your account the more history the credit bureaus have to judge your financial health. Establish good habits, like paying your balances on time, keeping a low utilization rate and applying for credit only when you need it, and you should see those practices reflected in your score over time.
