Understanding and Improving Your Credit Score

Your credit score has a huge impact on some of the biggest aspects of your adult life. You’ll likely need a decent score if you want to rent, lease or finance a car, open a credit card account, and of course, buy a home. To avoid making costly mistakes that harm your credit, you have to first understand how the process works.

When lenders and credit issuers evaluate an application, they usually want both your credit report and credit score. The score is a mathematical calculation based on the information found on your credit report. The score represents how much of a credit risk you may be to lenders. You have probably heard your credit score referred to as your FICO score, because the software used to calculate it was developed by Fair, Isaac, and Company, or FICO.

All the major credit reporting companies use FICO scores, but sometimes different sets of information on their reports. FICO scores range from 300 (the highest risk) to 850 (the lowest risk), and that score depends on many factors. The major factors are the following:

Bill Payment History

If you consistently pay your bills on time, that will be reflected in a higher, less-risky score. But if you’ve been late in payments, had debt sent to collections, filed for bankruptcy, etc., that will factor into a lower, higher-risk score.

Your Outstanding Debt

This is your total debt, including mortgage, car loans, student loans, credit cards, home-equity lines of credit, and any other type of loan reported to a credit agency. And while it may seem like lower balances will always result in better scores, a very important factor is how much available credit you don’t use. Those who use credit sparingly—about 10% of allowed and no more than 30%—will have the highest credit scores.

Hard Credit Pulls

If you have applied for credit several times in a short period of time, that will signal to lenders you may be a risky option. This risk results in a lower FICO score. However, multiple applications for a specific type of credit in a short time frame does not have the same negative effect.

Now that you know what your credit score is based on, it is easier to understand why those factors are important to lenders. Applicants with credit scores of 720 and higher receive the best deals. If your score is below that, there are ways to improve it:

Review Your Credit Report to Stay Updated and Catch Any Mistakes

Your score is based on information on your credit report, so any errors on the report could be costly for you even if you actually have a good credit history. Get copies of your report from the three main reporting agencies (Experian, TransUnion, and Equifax) and check each for mistakes. You are entitled to one free report from each company every year.

Pay All Your Bills on Time

Check to see if your credit report shows any late notices. If you have an otherwise good credit rating, you might be able to get the lender to remove the notice.

Reduce Your Credit Utilization Rate

Your score is higher when your debt is lower as a percentage of your available credit. Pay down whatever you can and stop using credit for large purchases. If you cannot pay it down right away, ask your lender to increase your available credit. This way, your outstanding debt will be a lower percentage of available credit…but you will need to resist the temptation to draw on any of that newly available credit. Make sure you never use more than 50% of available credit.

Keep Credit Card Accounts Open

This may seem counterintuitive, because once you’ve paid off a balance you probably want the satisfaction of closing it out. But when you close an account, you no longer have that available credit to count toward your utilization percentage. If you have more than five credit cards, close the newest ones so your long-term credit relationship stays in the report.

Consider Installment Loans If You Only Have Revolving Credit

Fixed-payment loans like a car loan or mortgage will increase the variety of credit in your report, and you will be rewarded in your FICO score.

Avoid Asking for More Credit as Much as Possible

Inquiries about more debt will show up in your credit file like hard pulls and will lower your credit score. Your credit score can have a significant impact on the cost of any debt you incur.