What is Credit Score and How to Improve It?

UTC by Osaemezu Ogwu · 10 min read
What is Credit Score and How to Improve It?
Photo: QuoteInspector

You’d be saving money year-in year out just by having a good score. But then, you need to understand how credit scores work. Employ the tips provided in the guide and find out how to improve your credit score.

A credit score is a statistical number that helps lending institutions to determine your creditworthiness. That is to say, if you’re likely to repay a loan and its interest within the stipulated time based on your credit history. The credit history consists of the total levels of debt, number of open accounts, and repayment history.

Therefore, whether it is a credit for a credit card, an auto loan or a mortgage you’re applying for, lenders take the extra step to ascertain the level of risk they’ll be taking by lending money to you. On the other hand, a credit score is calculated using the information provided in your credit report. The score enables the report to be evaluated.

Accordingly, lenders request for this report and depending on your credit score, it can impact the amount that is lent to you as well as the lenders’ terms for the loan. And most importantly, the score in the credit report “at a particular point in time” enables lenders to determine if you’re creditworthy.

Why Do We Need Them?

There are several reasons why you need a credit score and some of them are:

To Obtain a Loan

You may have dreams to set up your own business but lack the startup capital. Nonetheless, you can obtain a small business loan. Lenders, on the other hand, are more than willing to lend to people, however, they take a risk each time they do so. As such, these lending institutions use credit scores to decide whether you are the right candidate among the lot, to receive their money.

Get Approved for Higher Limits

How much you can borrow is also tied to your income and credit score. For this reason, you need a credit score to obtain more money from a financial institution, and this score must be a good one. A good score shows that you’ll be able to pay back the borrowed amount on time.

Contrastingly, you may have a high income but poor credit score, and that would mean you can’t be relied upon to pay back the monthly payments consistently and even the loan. That aside, even if you do get approved using a bad credit score, the amount you can borrow will be limited.

Receive Better Interest Rates

Your credit score can significantly determine if you’ll receive a lower or higher interest rate. For example, subprime mortgages, for fair credit score (around 640), are charged at higher rates compared to a conventional mortgage. The higher rate is to ensure that the upfront fee has been paid to curb the risk if you default on your payment. Similarly, a shorter repayment term or a cosigner may be needed if you have a low credit score.

In contrast, a good credit score (of at least 700) may give you a lower interest rate, and as such, you’ll be paying less during the lifetime of your loan. The same can be said about exceptional scores (higher than 800) since these are considered as excellent. Nonetheless, the creditor may determine the range of credit scores that will enjoy these reduced rates. Lenders may also review these scores occasionally to determine if the interest rate is to be changed or a credit limit on a credit card is to be placed.

To Obtain Other Services

Your credit score can also determine the size of the down payment you can make to obtain a car, phone, rent an apartment, utilities, etc. This is because the scores show your financial credibility and ability to hold up to your part of the deal. For example, electric companies may check your credit score to decide whether to restore your power. They believe that you’re borrowing one month of electric service, hence, they need to be certain you’ll be able to pay back.

In the case of buying a house, mortgage lenders will need the guarantee that you won’t default on your mortgage and your credit score can help with that. What’s more, the interest rates will either be increased or decreased based on your credit scores. Further, landlords may also use your credit scores to decide whether to rent to you or not.

How Credit Scores are Calculated

Various factors are employed in calculating your credit score. The FICO (Fair Isaac Corporation) and VantageScore models rely on the payment history but other factors are also used. Alternatively, credit score creators withhold the exact details used in calculating scores but they still provide estimates which show the most important factors.

In the U.S., for instance, Transunion, Equifax, Experian are the major credit reporting agencies. The trio reports and updates customers’ credit and different information may be sourced by each of them. Needless to say, the major factors these agencies put into consideration when calculating the credit score are:

  • The payment history
  • Total amount owed
  • Length of credit history
  • Credit types
  • New credit

The level of weight these factors have in calculating your credit score is determined by whether they are classified under the FICO Credit Score or VantageScore. Let’s take a closer look at each:

Payment History

Payment history makes up a greater percentage of your credit score because it accounts for 35% and 45% of your FICO and VantageScore, respectively. What this history show is your dedication to redeeming payments, and on time. It, therefore, helps lenders to determine if you’re likely to make future payments promptly. Late payments, on the other hand, can reduce your credit score, which is why it is advisable to make your loan payments or pay bills on time to maintain the best score.

Total Amount Owed

The total amount owned accounts for 30% and 20% of a FICO and VantageScore, respectively. This factor considers the credit percentage that is available to you and the percentage that is currently used. Credit scoring models can penalize you if you’re using a major proportion of the available credit. What’s more, you are considered as a less risky borrower if you owe less. The same can be said about keeping your credit card balance between 10% or 20% of your credit limits.

Length of Credit History

The length of credit history accounts for 15% of a credit score, and it is based on factors including the age of your newest and oldest account as well as the average age of all your accounts. This factor can be more or less risky. Longer credit histories are considered as less risky since it provides more data to ascertain the payment history.

Lenders would love to see a successful borrowing and repaying before lending to you since it goes a long way to show that you may continue with the same behavior. Over and above that, it takes a while to build credit but if you tend to meet payments, you’ll have better scores over time.

Types of Credit

The type of credit accounts for 10% of a credit score and it reveals if there is a combination of installment credit. For instance, there could be credit cards, car loans or mortgage loans, and revolving credit, etc. Scoring models also consider the credit mix that is or was used in the past, and lenders would want to see how well you can handle a different mix of loans.

Nonetheless, it may be tempting to apply for new loans just to improve your credit mix, but this is not always recommendable. The reason is, the costs of debt may be greater than the benefit derived from increasing the credit mix. Moreover, it is less important compared to other factors in your credit score.

New Credit

New credit accounts for 10% of the credit score. This factor determines the number of new accounts a person has, as well as, the number of new accounts they have recently applied for. These accounts may have resulted in credit inquiries, as well as when the most recent account was opened.

It is, however, worth noting that opening new accounts too fast may look like you’re facing financial difficulties, thereby lowering your scores. That being said, it is better to have fewer recent credit inquiries to maintain or improve your credit score.

Some Other Factors to Keep in Mind

Lenders rely on various factors to ascertain a borrower’s ability to repay loans. These are:

Credit Utilization: This is obtained through a division of your balances by the credit available. It accounts for 20% of the credit score.

Total Balances: This also your total debt and reducing this debt can increase your credit score. It accounts for 11% of the credit score.

Recent Behavior: It considers newly opened accounts coupled with the number of hard inquiries. If the number of either of these is high, it may reflect poorly on your credit report. This factor accounts for 5% of the credit score.

Available Credit: It centers on the amount of credit that is available for you to use. This factor accounts for 3% of the credit score.

How to Improve Your Credit Score

Given that credit scores are numbers and fall between a range, they can increase and reduce. Likewise, certain factors contribute to the range they fall under, which means these factors can either make or mar your score. Needless to say, your credit score can be improved in the following ways:

Pay Bills on a Timely Basis

It is entirely possible to increase your credit score just by paying credit card bills, phone bills, auto or student loans, utilities, amongst others. These bills need to be paid consistently for six-months at a stretch. For loans, payments can be paid as when agreed instead of paying late or using a lesser amount to settle an account. What’s more, you can also rely on automatic payments or other tools that will alert you so you don’t miss out on any bills.

Improve Your Credit Line

Increasing your credit card limit is another surefire way to have a higher credit score. All that is required is for your credit card accounts to meet the criteria of the payment, which will bring about a credit limit increase. Though you’ve got an increase in credit limit, you will have to spend less than the limit to ensure a low credit utilization rate is maintained.

Do Not Close Your Credit Card Account

For credit cards you are no longer using, you can stop using the account instead of opting to close the account. This is because the closure of the account could affect your credit score due to the age and credit limit of the card in question. Also, closing the account can increase your credit utilization ratio. The point is, owing to the same amount, yet maintaining a fewer number of accounts can reduce your credit score.

Minimize Applications for New Credit

It’s true that opening a new credit card could increase your credit limit. Nonetheless, the process of applying for credit could create a hard inquiry that will be evident on your credit report. If there are too many hard inquiries on this report, it could go a long way to impact negatively on your credit score. In addition, hard inquiries will reflect on your report for some years.