Updated Sept. 2, 2021, 9:13 p.m.
If you have made credit mistakes in the past, or are just beginning your credit history, read ahead to understand credit and discover the best way to improve your credit score.
Your credit represents your financial reputation, but it also grants you monetary leverage. An individual may use leverage as they borrow money to purchase big things that are otherwise unaffordable, like a college education, car, or home. Without good credit, what we may regard as debt-financed investments couldn’t be possible or might end up costing more.
Basically, you should be concerned about your credit score anytime you need a loan or are thinking about renting property. A good credit score is useful because it indicates to a lender that you are reliable to repay them. A risky borrower would not be entrusted with large amounts of money or would be less likely to be given the loan in the first place.
It seems that to move forward with your life, your credit score is considered every step of the way. It matters whether you are borrowing money to be able to afford something, starting a business, or moving into a new place. This is why it is important to understand the factors which influence your credit and why you should focus on improving your credit score.
It makes sense why an objective and unbiased way to measure financial credibility was invented. Your credit score was created as a way for lenders to know your likelihood and ability to pay them back. Various credit reporting methods were around, but the most prominent one appeared fairly recently.
The FICO credit score, which was introduced in 1989 by the Fair Isaac Corporation (FICO), can only be approximated. Though the FICO data analytics company has not revealed its proprietary formula, we do know the relative importance of the metrics used in the calculation of your credit score. These components of your score, along with their weights are summarized in the table below.
| Category | Weight |
| Payment History | 35% |
| Amounts Owed | 30% |
| Age of Credit | 15% |
| Types of Credit | 10% |
| Hard Inquiries | 10% |
In exchange for sharing credit information, your performance in all of these categories are reported by creditors to the three national consumer credit bureaus: TransUnion, Experian, and Equifax. These bureaus review your loan history from many sources including credit cards, home mortgages, retail store accounts, auto loans, and student loans. They each determine your score by applying your credit report information to the FICO algorithm. The result is a credit score which ranges from 300 to 850, with good scores exceeding 700.
A low score below 650 represents high risk borrowers, which makes it difficult to be approved for loans. It takes time and discipline to advertise to lenders you are trustworthy with their money. So how can you best make a good impression with your creditworthiness?
To improve your score, simply use loans responsibly while paying them off in a reasonably short amount of time. You probably knew that already, so let’s look at what influences each specific category and work on a strategy.
Your payment history carries the highest impact towards your credit score. This category is essentially what shows how reliable you are in paying your bills on time, so this is the first thing a lender wants to know. Credit reports track any credit damaging incidents, or lack thereof, to determine your performance in your history.
For most people, late payments are the primary mistakes which affect this category. If your bill is past due by 30 days, then it is usually considered as delinquent. The impact on your score depends on the frequency of occurrence, how long it took to resolve overdue bills, how much money was owed, and the amount of time that has passed. Other, more serious negative factors include whether you had bankruptcies, debt collections, lawsuits, or if your wages were garnished by court order. These can stay on your credit record for 7 to 10 years.
Your payment history is the most important category to manage. To improve this you will simply need to get back on track to consistently making more on time payments. Holding more accounts that are being paid as agreed can boost building credit. Over time, your older credit mistakes will count less towards your score and your new good habits will eventually raise it.
The amounts owed category can be thought of as your total debt burden. This major factor of your score considers the total amount of debt you carry and how much you use from your available credit. This category also looks at the number of accounts with balances, as too many may indicate a risk of overextension. The amount you paid down on installment loans counts as well, because repaying more of your debt is a sure sign of your responsibility. Now all these matter to some extent, but having and using debt as leverage doesn’t necessarily make you a high risk borrower.
The most significant contributor towards your score is actually your credit utilization ratio, also called debt to limit ratio. This refers specifically to revolving credit accounts like credit cards, and looks at how much from your credit limit you actually use. It is important for lenders to track because people who borrow larger amounts from their available credit are seen as a potential risk.
The highest ranking borrowers carry a remaining balance of under 10% of their monthly credit limit. Those who utilize more than 50% of their limit perform the worst in this category. A good rule of thumb is to never borrow more than 30% of your credit limit to maintain a good score. If you are having trouble with retaining low utilization, first try to decrease your spending or reduce using your credit cards to make purchases. If you must borrow large amounts of your available credit there are a few other solutions which may help.
One thing which you can use to your advantage is that creditors don’t automatically report your monthly expenses to the credit bureaus. Rather, what counts towards your score is usually the balance remaining at the end of your billing cycle. Keep an eagle eye and pay off each card in full immediately before charges appear on your statement. This is good practice that if timed well may help you attain near 0% utilization, since a lower amount will be reported.
As long as you borrow the same amount, by increasing your credit limit, your overall utilization will decrease. You may request to increase your credit limit on each of your cards if you meet certain criteria, like having a good payment history, or by using the card for some required time. You can also apply for additional cards to boost your available credit. Note that this only works if you don’t increase your spending. Just because you have increased your credit limit to $5000 doesn’t mean you should use more of it. Be careful not to overdo these requests for more credit as they count against your score as hard inquiries, a point which will be discussed later.
The next largest component of your credit score focuses on the age of your credit history. The longer you have had credit, the more experience you have paying off bills on time, which increases your credit score. Here, your most useful line of credit is your oldest, but the average age of all your credit accounts also plays a role in the score. Your oldest lines of credit should be kept active if possible. Keep in mind that opening each new credit account lowers this average, but with a longer established history each has less impact.
Each application for a new line of credit is a hard inquiry that slightly impacts your score temporarily. These hard inquiries only affect your score for 12 months but are displayed on credit reports for 2 years. Opening too many credit accounts at once may indicate to companies that you are under financial pressure, which further impacts your score. Especially for those with a short credit history, it’s best to avoid a high rate of new accounts because it will also reduce your average account age.
You should not do too much at once and consider the timing of your applications. Don’t avoid new lines entirely for this reason, as you must have credit to build credit. Just be aware that if you anticipate getting a loan within the year, for some time you will have a decreased score. This is an unavoidable part of gaining more lines of credit which will eventually help your score by increasing your available credit and lowering utilization.
Additionally, the types of accounts open are considered in your score. Lenders want proof that you are able to successfully handle multiple types of loans. You should ideally manage a mix of revolving credit like credit cards and retail store accounts as well as installment credit like mortgages, auto loans, and student loans.
It’s not a requirement to have one of each type, but having too few accounts does make it difficult to maximize your credit score. The downside of trying to fill missing elements of your credit mix too quickly is the connection it has to the hard inquiries category. Each inquiry will hurt your score for a year and too many at once is a sign of financial distress, which would make things much worse. So you should ideally space out your applications.
Because the categories are linked with each other, it seems there is a delicate balance to achieve in order to maximize your credit. However, there are a few straightforward guidelines to follow. The general strategy involves avoiding late payments of any loan, while keeping your revolving debt below 10% of your limit.
Set yourself up with a handful of credit accounts while mixing the types of credit if possible. Keep your oldest line of credit and refrain from closing unused accounts. You want to show that you can manage a diverse portfolio of loans. Apply for more credit once in a while, but avoid doing it too often especially if you know you will soon need to borrow a large amount. Maintain the best practices outlined above as your credit ages and your score will certainly improve.
Establishing your credit history is a long term strategy which takes a lot of discipline and patience. You might have to participate more than you intend if you desire excellent credit. But if you persist you will be rewarded with greater financial power to fund your future.
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