Once you have a credit card, you need to build your credit score in order to qualify for higher credit limits on that card and other financial services in the future (the same tips would apply to someone who is maintaining an already good score). Credit scores are determined by these 5 factors:
Payment History 35%
Amount Owed (credit utilization) 30%
Length of Credit History 15%
Credit Inquiries 10%
Types of Credit Used 10%
Here is a more detailed breakdown of these factors affect your credit score and how you can use them to your advantage to build your credit score, or maintain an already good score.
1. Payment History 35%
35% of your credit score is determined by how frequently you meet your credit card payments, if you miss even one payment, it can have a huge impact on your score. So what should you do?….
Always pay your credit card bill in full on time!
This is essential for improving your credit score and also making sure that you don’t pay interest. Credit card interest rates are very high compared to other forms of credit, put simply if you want to borrow money make a purchase and pay it back over several months, a credit card isn’t the best choice, there are other cheaper ways to finance purchases. Paying interest will also cancel out any benefit from cash back or frequent flyer points you may earn from your card.
So here are a couple of easy ways to make sure you can always meet not just the minimum payment, but pay your card off in full each month:
- Decide how much you intend to charge to your card that month, let’s say for example $200. First, move $200 into a savings account, then make purchases using your card, once you hit $200 on your card that month, don’t use it again, and return to making purchases on your debit card or with cash. Then when the bill comes you have the money ready to pay it off.
- Set up a direct debit from your checking account to pay the minimum payment on your credit card (minimum payments can be as low as $25 ). This will ensure you never have to pay any late payment fees, which can be around $35 dollars per missed payment.
2. Amount Owed (AKA Credit Utilization) 30%
This factor determines 30% of your credit score. If you owe a lot of money on your credit card, then this will cause your credit score to decrease. But it is not as simple as the more you owe the lower your credit score. It is the amount of money you owe as a percentage of the amount of credit you have access to, across all credit cards, loans etc… that appear on your credit report. This is called Credit Utilization.
Here is a simple example: If a person has access to a credit line of $1000 and they owe $500, they would have a credit utilization of 50%. But if another person had access to a credit line of $4000 and owe $1000, they would have a credit utilization of only 25%, and thus be in a better situation for maintaining a good credit score than the first person, even though they owe more money. So what should you do?
Maintain low credit utilization!
Typically it is advisable to maintain credit utilization of 30% or less, in order to avoid this factor having a negative impact on your credit score. If you are preparing to apply for a new credit card or other financial product it is even advisable to go below 10%. But, don’t for get credit utilization is measured as a percentage of all the lines of credit you have access to added together. So one way to lower your credit utilization could be to apply for a credit limit increase (CLI) or to get an extra credit card in order to increase the overall credit line you have access to, while keeping your spending the same. Thus your credit utilization will drop, and it will have a positive impact on your score.
3. Length of Credit History 15%
This is something young people or new immigrants to the United States will struggle with, their cards simply haven’t been open long enough, and thus have a negative influence on their credit score. Luckily this only accounts for 15% of your score. So what should you do?
Keep credit card accounts open, even if you don’t use them anymore
This factor is measured by the average age of all the credit card accounts you have, so if you have “graduated” from a basic card to a more premium card, keep the basic credit card open, even if you never use it. This won’t hurt you, since most entry-level credit cards have no annual fee. In-fact, you can even consider opening a few “no annual fee” cards, and leave them sitting there to increase your “average age of account.”
4. Credit inquiries 10%
There are two types of credit inquiries: hard and soft. Hard inquiries are the only type you need to worry about. Hard credit inquiries occur when a lender checks your credit report in order to make a lending decision e.g. when you apply for a credit card or a loan. Soft inquiries occur when you check your credit yourself or a company checks your credit as part of a background check or when you are pre-approved for a credit card. Soft credit inquiries can occur without your permission, but hard inquiries generally won’t.
Hard credit inquiries can cause your score to decrease by 2 – 4 points, but it will usually rebound after 6 months or so. But multiple hard inquiries in a short time can give the impression you are desperate for credit, and cause significant damage. So what should you do?
Limit hard credit inquiries to one or two per year
By limiting hard inquiries to every six months or so, you allow your score to recover. Since a hard inquiry can only knock off upto 4 points, this will become less crucial when your credit score is higher and you have more of a buffer zone. Remember hard inquiries still knock points off your score, even if you are approved for the application they relate to.
5. Types of credit used
Diversifying your credit accounts can help improve your credit score. There are three types of credit accounts
- Revolving – where you make different payments each month, depending on how much you spend. You can choose how much you pay back, and pay interest if you don’t pay in full. E.g. credit cards
- Installment – where you may a fixed amount each month until the balance is paid off. E.g. mortgages or auto loans.
- Open – Where you pay what you owe in full every month, but they amount you owe may vary. E.g. cell phone account or charge card.
Only revolving and installment accounts will report to the credit agencies on a monthly basis, generally open accounts will only be reported if you miss a payment and thus don’t really help you improve your score. Having an installment account like a mortgage or auto loan at the same time as having a credit card will help to increase your credit score. Yet from another point of view can also have a negative impact, if you can’t meet the payments on time. So what should you do?
Consider opening installment credit accounts in addition to revolving accounts (credit cards) if it is within your means to do so
Diversifying your credit accounts will help your score. It will especially show maturity in your accounts. But it could get you in trouble if you are unable to meet payments. So only take out loans if you really need them, and have the capacity to pay them back. For many people just starting out on this path, you may wish to just forget about this factor for now, since some of these financial products (like mortgages) are big life choices, and thus cannot be done just to improve your credit score!
So, now you know what can affect your credit score, how do you check your score? Check out the next article to find out…