What's a Credit Score?
You’ve heard this term many times, especially if you’ve been considering purchasing a home, car, etc. - but what does it really mean?
Having a good credit score is an important part of your financial life. At the very least, it will affect the type of interest you’ll pay on any type of loan, from home mortgages to credit cards. At most, a low credit score will seriously impact your ability to purchase a house or a car. Yet a lot of people still have doubts as to how credit scores work and why it’s important to make sure the information contained in your credit report, which is the basis for your score, is correct.
Know What Goes into Your Credit Report
Knowing the information that goes into your credit report is important not only because it will give you an idea of your financial health, but also because it can help you identify inaccurate information. It can also help identify if you’ve been the victim of identity theft.
“Your credit report can be one of the first sources to help protect you and help you recover from fraud,” says Rod Griffin, Senior Director of Public Education for Experian. “It’s also an account management tool. When you get your credit report you’ll be able to see all of your financial debt-related obligations and help you manage them more effectively.”
Learning the ins and outs of credit reporting can be confusing if you don’t know where to look. The first step is to obtain and review your credit report at least once a year. Next, you want to know what information goes into creating your score and what factors can negatively affect it. Finally, you’ll need to know what you can do to help improve your score if possible. Your credit report will include a list of risk factors that can reduce your score. “Get those risk factors,” said Griffin. “They will tell you exactly what you need to work on in your credit report to make those scores better.”
Know What Makes Up Your Credit Score
Your credit score is composed of five categories: your payment history (35%), the amounts you owe (30%), the length of your credit history (15%), your credit mix (10%), and new credit (10%). Changes to any one of these categories can change your score, so maintaining a good score entails making payments on time, not owing too much, having a good balance of different kinds of debt (mortgages, credit cards, installment loans, etc.), opening new credit lines, and not using too much of your available credit.
Some less serious factors that can lower a credit score include not having a long credit history or having a high credit utilization. For example, someone who only has one or two years of payment history may not have a high score simply because there isn’t enough information for the lender to decide whether they are creditworthy. Another example is someone who has three credit cards with a $30,000 total credit limit between the cards. If they only carry a debt of $5,000 on those cards their credit score will be higher than if they carry a debt of $25,000.
Other factors that reduce a credit score, however, are much more serious and can have a longer-lasting effect on your ability to obtain new credit.
Negative Impacts on Your Credit Score
The following behaviors will not only lower your credit score and cause trouble in your financial life, but they will also stay on your credit report for up to seven years in most cases, significantly impacting your ability to obtain new credit or qualify for lower interest rates:
Late Payments or Non-payment: Payment history accounts for a large chunk of your credit score, so if you are chronically late or not paying at all, it will hurt your score significantly. It also signals lenders that you cannot afford, or are unwilling, to pay your debts.
Having a charge-off: A charge-off happens when a creditor has given up on you ever paying your debt and they “charge off” your account. This could cause a credit score drop of 100 points or more in some cases.
Bankruptcy: Bankruptcy is an extreme measure and will hurt your credit score by up to 200 points or more. It also stays on your record for seven to ten years, depending on the type of bankruptcy.
Foreclosure: A foreclosure is another red mark on your credit that can cause a credit score to drop substantially.
Repossessions: If your car is repossessed, the credit bureaus may include a note about the repossession in your credit reports that stays for up to seven years. A repo can include many of the negative line items you see here, such as late or non-payment, so the score drop can easily go over 100 points.
Judgments: A judgment comes when a court is forced to get involved to ensure debt repayment. Credit score impacts can vary but the drop could also be over 100 points.
Collections: A collection occurs when a creditor resorts to hiring an outside firm to collect payment. Collections fall under payment history, so the hit to your credit score can also be over 100 points.
