Credit scores are important. A good credit score makes it easier and less expensive to borrow money, but it also impacts insurance rates, job hunting, deposits for utilities, and even your security clearance as a military member. Unfortunately, there is a lot of misinformation about what actions impact your credit score and the best ways to maintain a good credit score.
While there are dozens of different credit scores, they all use a very similar group of information to create your individual score. Not every score shares their math, so we are guessing about some of them, but we do know a lot. The five main components for most scores include payment history, amounts owed, length of credit history, new credit and credit mix. Let’s talk about some of the facts and myths about each component of your credit score.
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Payment History
Payment history makes up the biggest part of almost all credit scores. Your payment history includes whether you make your payments on time, if you have any delinquencies, how long those delinquencies lasted and how much money was delinquent, and when those delinquencies happened.
Myth: Once you are behind on an account, it doesn’t matter what you do.
Reality: You want to catch up as quickly as possible, and avoid repeat delinquencies, to show that it was an unusual event. Credit reports show late payments in 30 day increments, and a 30 day late payment is better than a 60 day late payment. Plus, the further behind you are, the harder it is to catch up.
Your Credit Utilization, or Amount of Debt
Credit utilization rate is an industry term that describes how much of your available credit you have used, as a percentage of the total credit available. If you have a total credit limit of $1,000 across all your accounts, and your total outstanding balances add up to $300, then your credit utilization rate is 30%. Amazingly, you could also have a credit utilization rate of 30% with a total outstanding balance of $30,000, if your total available credit is $100,000.
While the general rule is that you should keep your credit utilization rate under 30%, a study of those with the highest credit scores show that they keep their credit utilization rate under 10%.
Myth: It hurts you if you pay your credit card bills in full each month.
Reality: Not using any credit at all may impact your score, but paying your credit card off entirely each month does not hurt you. Creditors report your balances monthly, typically on the statement date. So even if you pay the entire balance on your credit card every month, you’ll still show both a positive payment history and ongoing small balances each month.
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Length of Credit History
How long you've had credit may impact your score. The most popular credit score, the FICO score, calculates 10% of your credit score based upon the length of your credit history, including the age of your oldest account, the age of your newest account, the average age of all your accounts, how long it has been since you used each account, and how long specific accounts have been open. If you’re new to credit, though, don’t despair. A positive payment history and a low credit utilization rate are much more important than the length of your credit history.
Myth: Closing accounts always hurts your credit score and should be avoided.
Reality: The impact of closing a credit account will depend on the type of account, how often you use that account, the age of the credit account, and what proportion of your overall credit is attached to that card. The impact on your credit utilization rate is likely more important than the impact on your length of credit. In many cases, there is no impact or a very small impact that lasts only a few months.
See: 7 Steps to Help Rebuild Your Credit Score
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Credit Mix
Credit mix means the different types of credit that you use. Different credit score models may weigh credit cards differently from mortgages or car loans or personal loans.Myth: You need to have a mortgage or car loan to build a good credit score.
Reality: Credit mix represents a small portion of your credit score, and most people naturally build a mix of credit over time. In most cases, not having a mix of credit is not going to impact your score enough to affect any decision making.
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New Credit
Opening new credit may have a slight impact on your credit score, but that works in many directions. Applying for new credit may make you riskier, because you may have more debt to pay, and new credit reduces the average age of your credit. If you take out a new loan, you’ll change your credit utilization ratio because you’re adding available credit but you are also adding a balance. But a new credit card may represent new available credit with actually adding to your overall balance.
Myth: It hurts your credit if you comparison shop for a car loan.
Reality: Credit scores don’t penalize you for applying for similar credit within a short period of time. Let’s say you apply for three different car loans (or mortgages, or student loans) today. The credit scoring math will treat that as one inquiry, not three.
Credit is a tricky business, and understanding it thoroughly can help you make the best decisions for successful credit management!
