Smart toddler learning basics

So far, we’ve been talking about how to improve on credit scores, what to do keep them at a high, and what not to do in order to hurt it. We’ve also been talking about how a credit score can influence many of your transactions, even those activities that do not necessarily revolve around credit.

However, now is the best time to address a very basic issue: just what exactly is a credit score? To add to that, why does it matter that you keep it within a certain range? To answer these questions, we’d have to break a credit score down to its most basic of components.

The Components of a Credit Score

All credit scores have the same function in the sense that they are 3-digit figures that will tell lenders if you can be trusted with a loan or credit. Regardless of which company prepares your credit report, the components of a credit score are basically the same from one region to another. This basically means that, regardless of who makes your credit score, that score will be affected by the same factors such as:

1. Payment History

Considered to be one of the most important components of your credit score, your payment history details your behavior as a credit holder. This, in turn, will give creditors an idea as to how trustworthy you are when it comes to fulfilling your obligations.

Credit reporting agencies have their own treatment when it comes to payment history although you can be certain that they’d be on the lookout for several payment entries.

  • Revolving loans: this includes your typical credit loans which you have to constantly pay every month or when you reach your credit limit for that same month.
  • Installment loans: these are simply loans that you have to pay on a gradual basis like student loans and mortgages.
  • Automatic payments: these are the kinds of payments instantly charged to your account and removed subsequently on your available credit on a monthly, bi-monthly, quarterly, or annual basis. This includes monthly utility bills, subscriptions, club memberships, and even some types of loan payments.

There are even instances when missing a payment will not negatively affect your score. For instance, a lot of creditors are more lenient towards instalment loans as opposed to revolving loans which means missing payment on the latter before they submit a report to the agency won’t hurt your credit score. Of course, this is only if you’ve only skipped once, not doing this several times over.

2. Credit Utilisation

Another major factor is your utilisation ratio. To compute this, agencies simply compare your available credit over the credit you have used. For instance, you have £5,000 worth of available credit in your account but you have a credit limit of £10,000 on all of your cards. By dividing your credit limit with your available credit, you get 0.5 which means that your current credit utilisation rate is 50%.

How you maintain a balance between available credit and used credit will ultimately shape your utilisation rate which affects your overall credit score. Even going near the limit can be bad for your score as an increase in your used credit will cause a spike in your utilisation rate.

3. Credit History

This is basically the age of your entire credit history. To get this, agencies simply determine which of your credit cards are the oldest. Naturally, your credit history begins at the moment you applied for your very first credit card.

Out of all the credit score components, this is perhaps the easiest factor to ace as you simply have to keep your accounts open for as long as possible in order to get a good score. Simply put, the older your first account gets, the better your credit history will be.

Here’s the kicker, though: if you decide to close your older accounts, you are effectively wiping away portions of your credit history, both good and bad. So, if you close your first credit card, you will basically delete that portion of your credit history which shortens it. This would eventually cause your credit score to drop.

Also, beware when it comes to fraud when you happen to be in the situation that the card has been lost or stolen that the credit card company will put an instant stop to that credit card account and open a new account which will resemble your old card but they may reset the account opening date to now thus losing the matured date – So keep those old cards safe!

4. Credit Mix

Credit agencies also look into the types of credit you have in order to come up with your credit score. You’d naturally think that more credit accounts lead to a better score. The truth, however, is far more complicated.

Although it is true that having a diversified list of credits i.e. a “credit mix” is a sign of a healthy credit account, these types of credits should have not been acquired at roughly the same period of time. Simply put, applying for multiple new credits is a telltale sign for lenders that you are in dire straits and need a loan which you may or may not be able to pay for in the future.

Also, applying for credit prompts the lender to do a hard enquiry on your account. Every hard search they make (done with your consent, fortunately) slightly affects your credit score. So imagine the drop in your score if multiple companies do hard enquiries on your account.

Why Does it Matter so Much?

So, what’s the point of having a good credit score? To put it simply, a credit score is your financial reputation reduced to digital form. It will precede you in whatever transaction you make and determines how successful you are when conducting these transactions.
The effects of an average to good credit score are instantly felt like being cleared for almost all types of credit and a generally faster pace of paperwork for your application. But what happens if, say, your credit score dips into the 600-350 range? The effects could differ from person to person but they may include:

Employment Difficulties

Believe it or not, a lot of employers today would check an applicant’s credit score. They’d usually do this to see if a) applicant’s financial status is a reason why they are applying for the job or b) if applicant has a history of good or bad financial management skills.
The latter is quite important in any job that requires the person to handle a considerable amount of money. After all, if that person has had difficulties dealing with their own money, what’s stopping them from mismanaging the finances of others?

Rental Issues

So, imagine yourself trying to look for a new place to stay in. While dealing with an owner of an apartment conveniently placed near the center of the town, the landlord immediately requests to see your credit history. As of late, landowners have been doing more credit checks with their potential tenants as they would want to be certain that those people have the ability to constantly and consistently pay rent. Depending on your score, then, your application as a tenant could either be approved or turned down.

Future Loan Applicants

Perhaps the most direct of the negative effects of a bad credit score is your inability to secure loans when you need them the most. A lender would obviously pull up a credit check to see if you had a history of missing payments. Sure, one missing payment is hardly any concern but more than a handful committed over a considerable period of time will hurt anyone’s chances of applying for new credit. Also, this stagnation in your credit mix is going to hurt your score even more.

What a Good Credit Score Looks Like

Regardless of which credit reporting agency prepares your score, what is considered as the ideal credit score range begins from 660 and goes as far as 750 and beyond. A credit score somewhere in between 650 to 690 might give you negligible benefits but it should be enough to make sure that most of your transactions are approved.
A score of 700 and beyond, however, will ensure that you can apply for new credit cards, loans, rents, and other services without a lot of problems. So how does one get their score to reach the 700-750+ range? Credit agencies are always on the lookout for the following factors.

  • Consistent and regular payment of debts
  • A credit utilisation rate of no more than 30% of the given credit limit
  • At least one credit card with minimal delinquent payments and has been active for more than 5 years
  • Diverse credit types applied through a considerably long period of time

Any of these would be enough to raise your score by several points so imagine how tremendous an increase your credit score experiences if the agency notices all of these in your history.

In Conclusion

In a nutshell, your credit score is your relationship with debt reduced to a 3-digit number. It is determined by your past transactions which, in turn, determines the success of your future transactions. Keeping it within a range that credit reporting agencies are comfortable with should do more than enough in ensuring that your credit-based lifestyle is as healthy as possible.

What other factors do you think might affect a credit score? Do you really believe that a credit score should have that great an impact on all your future financial transactions? :Let us know in the comments below!