How Credit Scores Work & Your Credit Score Explained

By on February 1, 2013

Credit Score ExplainedAre you the type of person who pays close attention to your credit score? Or are you the type who doesn’t even know what a credit score is? It doesn’t matter if you are young or old, rich or poor, unemployed  or employed; you should have a good understanding of your credit score.

You may not think your credit score is important now, but you could be in for a big surprise in the future. Ever want to purchase a new home or car? Tough luck if your credit score is not high enough to be approved. Now what are you going to do?

In this article, I will:

  1. Explain what a credit score is,
  2. Explain how your score is calculated,  and
  3. Share 5 ways you can boost your score.

What is a credit score?

Your credit score is a number that reflects how good you are when it comes to borrowing and paying back money. There are three companies that report credit scores, all of which have a similar system for calculating your score. They include:

  1. Experian (http://www.experian.com/)
  2. Equifax (http://www.equifax.com/home/en_us)
  3. TransUnion (http://www.transunion.com/)

From your credit cards to your car loans to your department store charge cards, your credit score takes everything into consideration. The three companies listed above analyze your report, calculate your number, and supply it to you or creditors and financial institutions upon request.

A credit score ranges from 300 – 850 with the higher score always being better.

There are five components that make up a credit score. These include: payment history, amount owed, length of credit history, inquiries, and types of credit.

Let’s take a closer look at each one:

  1. Payment history. A large majority of your credit score depends on your payment history. Are you in the habit of always paying your bills on time? Good for you. You are helping increase your credit score. Remember, 35 percent of your score is based on when you pay your bills. Don’t be late and you will never have a problem.
  2. Credit utilization and amount owed. This makes up a large portion of your credit score, checking in at 30 percent. How much of your available credit are you using? For example, if you have a credit card with a $10k limit and you are only using $2,000, the utilization rate is 20 percent. Lower utilization is better because it shows that you are not relying on credit to pay your bills.
  3. Length of credit history. As you can imagine, this is based partly on age. If you are in the 18 to 21 year age range, you likely don’t have any credit to report. This can be a good thing because you are starting fresh. Of course, you have to start building your credit at some point. The age of the accounts reported on your credit report account for 15 percent of your score. The longer you have an open account, as long as you pay on time, the more positive the effect will be on your score.
  4. Inquiries. As silly as this sounds, the number of inquiries about your score does affect your credit score. For example, opening several credit cards at the same time could harm your score. You don’t want multiple companies inquiring as to your credit score within a short period of time. Since this determines 10 percent of your score, don’t get into the habit of opening several accounts or applying for numerous loans at the same time.
  5. Types of credit used. Believe it or not, having a diversified credit report is better than only relying on one or two accounts. This holds true even if you are making payments on time and have a low utilization rate. To ensure more diversity, you could have some or all of the following: credit cards, mortgage, car loan, and utility bills.

4 tips for improving your credit score:

Now that you have a better idea of how your credit score is calculated, there are a few things you can do to improve your situation:

  1. Start slowly if you are young. One credit card account, for example, is enough to get established.
  2. Make payments on time, every time. There is no two ways about this.
  3. Never carry a balance on a credit card, unless you absolutely have to.
  4. Monitor your credit score and report for errors and suspicious activity.

Final Word

Even if you have no plans of applying for a new credit card or loan in the immediate future, you should still care about your credit score. This is something that is attached to you, no matter what, for your entire life. You might as well do whatever you can to maintain a high score.

Chris Bibey

About Chris Bibey

Chris Bibey is a freelance writer based in Pittsburgh, PA. With more than seven years of industry experience, he has published two books and has hundreds of articles in print and online. Follow Chris on Twitter or Google+.

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