Very easily one of the most important aspects of having a good credit score, is to understand how exactly how credit scores work. By understanding this, you'll be well ahead of 90% of the people out there with your knowledge.
Your score is broken up into 5 different areas: (explanations to follow)
1. Payment History
2. Debt to Credit Ratio
3. Length of Credit History
4. Types of Credit Used
5. New Credit Applications
Payment History – 35%
This is the largest portion of what makes up your credit score. I think that most people understand that making payments on time will help, and missing payments is going to hurt a credit score. The longer a payment goes unmade, the more damage it will do to a credit score. An example of that is a 30 day late payment isn't going to hurt your credit score nearly as much as a 90 day late payment. The saving grace is that late payments only affect your credit score for 24 months from the date the payment was missed.
If you do ever find yourself in a position of being behind with payments, do everything in your power to set up some type of arrangements with the creditor to get the payments current. If the account gets charged off, and sent into collections then your score will be affected for far longer than 24 months. In fact that's when the real long term trouble starts.
Debt to Credit Ratio – 30%
The next largest percentage of how credit scores work is debt to credit ratio. Exactly what does this mean though? In order to better understand this, it's important to know the two types of accounts that make up your credit history.
1. Installment Loans – Examples of these are mortgages, auto loans, and student loans. These have fixed payments for a specified amount of time.
2. Revolving Loans – Examples of these are your standard credit cards from Visa and MasterCard, as well as American Express and Discover. These are far more important when calculating your credit score.
Your debt to credit ratio is directly tied to the amount of debt in proportion to your balances on your Revolving credit loans. What that means is that installment loans, don't hold nearly as much weight as it pertains to your credit score … as long as you make your payments on time with these that is. To figure out what your ratio is real simple. All you need to do is add up your total credit limits, write that down. Then add up what you owe on each card, write that down. Then divide your total balance into your total allowed credit limit and that is your debt to credit ratio.
Example: John has 3 credit cards that each have a $ 1,000 limit on them. He owed $ 400 on each card.
Total Credit Limit: $ 3,000 Total Balance: $ 1,200
1200 balance divided into 3000 limit = 40% Debt Ratio
If John wants to get his score up there is a couple of ways he can go about it:
1. Pay down his balances to where they are combined no higher than 30%. The lower the debt ratio, the better it will be for Johns credit score.
2. Get limit increases on all of the revolving accounts if possible. This will instantly lower his debt ratio and increase his score.
3. Get more revolving accounts. Contrary to popular belief, the more credit that is available the higher Johns score will be. In fact, all things being equal, someone that has $ 20,000 limit is always going to have a higher credit score than someone that only has $ 5,000. Higher limits = higher scores
Length of Credit History – 15%
The next portion of how credit scores work is the length of credit history. To keep this simple, the longer you have credit, the better it will be for you. If you have very little credit established it will take longer to raise your credit score than if you have a lot of established credit for years. The people that have credit scores in the high 700's or even low 800's have had years of good payment history, high credit limits with low balances.
A tip when establishing credit, and more importantly revolving lines of credit, is to never close an account. Keep your accounts active forever. All that will do by closing an account is take away from length of credit history and increase your debt to credit ratio. Less open / available credit = lower credit scores.
Types of Credit Used – 10% of Your Credit Score
This is a more passive portion of how credit scores work, but is very important if you're looking to maximize your score. Again there is two types of accounts, installment and revolving, and having a good proportionate balance of the two is part of the calculation of your credit score. What that means is that if you have 4 credit cards, having 4 installment loans will be a good mixture.
New Credit Applications – 10% of Your Credit Score
The final portion of how credit scores work is new credit applications. What that means is that anytime you apply for credit, your score will drop because of an inquiry. (Note: If you only apply for one card, there is a chance your score won't drop, but if you apply for a lot of credit within a short time frame you can drop your score significantly) The thinking behind this is that the credit bureaus will penalize you because you're looking to get into more debt.
For inquiries when rate shopping for a mortgage or automobile loan, inquiries within 30 days will not affect your score if you get approved for a loan within that 30 period. For lenders using an older FICO scoring model, you will only have a 14 day window.
Credit inquiries only remain on your credit report for 24 months, and will have less impact as they get older. Also, when you pull your own credit you don't get an inquiry. An inquiry or application only happens when you apply for credit.