Your credit score, though seemingly insignificant, can directly affect your financial well-being. We’re covering what a credit score consists of and a few ways you can build your credit.
What is the purpose of a credit score?
Just as companies have credit ratings that investors can use to determine their creditworthiness, the same concept exists for individuals. This is to protect banks and lenders against default when approving a car loan or backing a mortgage.
A higher credit score indicates to a lender that an individual has a solid history with credit and will be unlikely to default on a loan payment. Because the credit score is directly associated with the risk of extending a loan to an individual, someone with a higher score is deemed to be less risky. This then translates directly to the interest rate assigned for a loan. Someone with a lower credit score will be given a higher interest rate because they are deemed more likely to default.
How is the credit score calculated?
Your credit score is calculated using the following five components:
- Payment History (35%)
- Lenders want to know you have a history of making payments on time
- Amounts Owed (30%)
- This is another word for “credit utilization”. It is the ratio of credit used to your total available credit. A high credit utilization may indicate that an individual is overextended and could pose a risk of default. You want your amounts owed to be low as a percentage of your available credit
- New Credit (10%)
- This is the count of credit inquiries you have in the last 12 months. Opening too many credit accounts in a short period of time can have a negative effect on your score.
- Length of Credit History (15%)
- Longer credit history has a positive effect on your score.
- Credit Mix (10%)
- Having a mixture of credit types (revolving and installment are the two primary types) has a positive effect on your score. This does not mean it’s good to open numerous accounts.
Now that we’ve covered the basics of the credit score, here are four simple ways you can build credit.
#1: Don’t make late payments
Payment history accounts for the largest portion of the credit score calculation, with 35%. It’s important that you make your payments on time to avoid being docked for a late payment.
#2: Authorized Users
If you have a trusted friend or family member with a solid credit history, you can ask to be added as an authorized user on their credit card account. This gives you credit history, available credit, and can help you establish credit. You don’t even have to have a card to be listed.
#3: Don’t carry over balances
Credit utilization is a large component of the score (30%), so you want to make sure you are keeping your ratio of credit used to total available credit low. If you have a large purchase, it may not be wise to make it with the credit card, especially if you plan to carry the balance over multiple payment periods. In general, you should be paying the balance off in full every month.
#4: Request higher credit limits
A higher limit, assuming the balance remains the same, lowers your credit utilization. This is a positive for your credit score. You can request credit limit raises with the credit card company. We don’t suggest this if you think you are at risk of increasing your spending along with the higher limit.
It’s important to track and manage your credit score. However, don’t lose hope if yours is low. In addition to the four we covered, there are a number of safe ways to improve your score and build your credit.