A credit score gives you the ability to borrow money.
If you have a good one, you will have more opportunities in your future to borrow money for a car, house, or take out a new credit card with lower interest rates.
If you have a poor one, you will have fewer opportunities in your future to borrow money and may not even be approved.
Understanding how a credit score is calculated will allow you to improve it. Certain areas will impact your score more, such as your payment history. Others will impact your score less, such as credit mix, but are still important aspects of your total score.
There are five categories that make up your score:
- payment history
- amounts owed
- length of credit history
- credit mix
- and new credit
Each category is weighted differently and will impact your score differently.
The 5 Categories of Your Credit Score
Payment History
The most important category of a credit score is payment history. This area is 35% of your score.
Payment history is the largest factor because this is an indicator and predictor of how likely you are to pay back your debt. Your payment history tells a lender what type of accounts you have and how you have those accounts.
Making on-time payments will give you a higher score in this category. Lenders see you as someone who will pay back their money on time with no issues.
Making late payments, missing payments, or being in a delinquent status will cause your score to suffer.
Lenders will see you as someone who cannot pay back their money on time. This lack of trust could result in being given a higher interest rate (in turn causing you to owe more money) or not being approved for a new line of credit or loan.
If you are trying to improve your credit score, the first place to start is to ensure you are making on-time payments.
Payment history is the highest weighted category and should be something to work on improving. Set up automatic payments on any loans to guarantee you are not missing any due dates.
10 Smart Ways to Build Your Credit Age & How it Affects Your Credit Score→
Amounts Owed
The second most important category of a credit score is the amounts owed. This area is 30% of your score.
Payment history and amounts owed make up more than half of your credit score and are crucial to improving it. Your amounts owed on your credit report is the total amount of debt that you have and how much of your credit limit is in use.
If you owe a large amount of money and are maxing out your credit limit, lenders will see you as a risky person to lend money to.
They may see you as overexerting yourself and decide that you cannot handle any more debt. If you don’t have a lot of money that you owe and are utilizing a low percent of your credit limit, your score will be higher.
Lenders will see that you can take on more debt because your utilization ratio is lower.
Focus on reducing your utilization ratio by paying off your credit card balances and other loans if you are trying to improve your credit score. This will improve your score and is just as important as payment history.
Length of Credit History
The third category of a credit score is the length of credit history. This area is 15% of your score.
Length of credit history is how long you’ve had a credit history. This number is an average on all of your accounts. The longer your credit history is, the better your score is.
Lenders see a longer length of credit history as more favorable because there is more data on the type of borrower you are. If you are young and your length of credit history is also young, don’t worry because you have time to build this area.
Credit Scores 101: How Does it Impact You Now and in the Future?→
Credit Mix
The fourth category of a credit score is credit mix. This area is 10% of your score.
Your credit mix is the different types of accounts that you have. This mix can be credit cards, installment loans, mortgages, and so on. The more diverse mix you have, the more this category positively impacts your score.
As you go through life, you will slowly get more diverse types of credit. This category is a small percentage and is not one category to fret about too much. Don’t open accounts to get a more diverse mix because this could impact your score negatively.
New Credit
The fifth category of a credit score is new credit. This area is also 10% of your score.
While the last three categories have smaller percentages, they add up to 35% of your credit score, which can improve your credit score if you focus on these categories along with the first two.
Whenever you take out a new line of credit, your credit score will take a small hit.
If you’re opening up new accounts in a short amount of time, then your score will be negatively impacted. Every time you apply for a loan, your credit report is run, also known as a hard inquiry.
Hard inquiries stay on your credit report for two years. While 10% is not a huge percentage, this area can help you go from a good to a great score. Limit how many lines of credit you are applying for and only apply if you need to.
Takeaway on Credit Scores
Credit scores are calculated in five categories that are weighed differently.
Each area is an important part of your score. There are actions you can take in each category to help improve your overall score.
