Managing your credit and knowing what factors play into determining your credit score are key ways to boost your financial wellbeing. On the most recent edition of Millennial Monday,Crystal Kessler and Justine Hall dive into all things credit and explain why maintaining a strong credit score is crucial, how to achieve such a score and how to select the right credit card for you.
For audio, see Your Credit Card Survival Guide.
What’s Your FICO Score?
Credit can seem like a complex topic from the outside, especially if you’ve never applied for a credit card or haven’t checked your credit score in some time. People will sometimes avoid applying for credit cards because they’re afraid of over-spending or developing bad habits in paying off debt.
While debit cards can appear to be easier to use, other than being convenient, they don’t help you build credit. This is especially important for young people as it’s helpful to start building credit as early as you can. Length of credit history is a main factor that goes into determining your FICO credit score.
What is a FICO score? Simply put, it’s a measure most commonly used by lenders to determine the risk involved in doing business with a borrower. Multiple systems exist, but the one most commonly used today was created by the Fair Isaac Corporation, known today as FICO, to establish a way of quantifying a borrower’s credit risk. “Erin Lowry of Broke Millennial calls credit scores your report card for life,” Hall said. “That sounds intimidating, but it really doesn’t have to be that bad. Credit scores can actually be our friend.”
Prior to the development of credit scores, Hall explained, obtaining a loan was subjective, and bias was common as bankers essentially decided to lend to someone if they seemed like they’d be able to pay the loan back, which was especially damaging for women and minorities.
How Is Your FICO Score Determined?
While FICO won’t reveal its secret formula, the factors that determine your credit score are fairly well known. There are five major components that determine your score, each with varying levels of importance. The first, and most important, is timeliness of credit payments, which accounts for roughly 35 percent of your score.
The next determining factor is what percentage of all outstanding lines of credit you are actively using. This refers to your overall borrowing limit, and how much you’ve accessed already. It accounts for 30 percent of your score.
Another metric that influences your FICO score is the length of your credit history, with a longer credit history being preferable. This makes up 15 percent of your score.
New credit inquiries, depending on the type of inquiry, influence your score as well. This is important when you’ve applied for multiple lines of credit in a short time frame, and accounts for roughly 10 percent of your score.
The last factor has to do with the number and types of credit you have. Student loans, mortgages, auto loans and credit cards feed into this. If you’re paying your loans on-time according to your payment schedule they can actually help to raise your score. These all account for about 10 percent of your credit score.
How to Raise Your Credit Score
Raising your credit score starts with developing healthy credit habits. These include making on-time payments on your credit cards and other loans. If you do happen to miss a payment, credit card companies may be willing to work with you, Kessler explained. They might be able to offer you a 30-day grace period if it’s the first time you’ve missed a payment and you’ve previously made all your payments on-time. This way the first missed payment won’t negatively affect your score, but you won’t know unless you call your credit card company and ask about your options.
Another important tool in developing and maintaining good credit is to make sure you don’t use more than 30 percent of your total credit limit, if possible. If you have combined credit lines with a maximum of $10,000 you won’t want to exceed spending $3,000 on that card in a month.
To establish a long credit history, open a line of credit as soon as possible, and keep it open indefinitely. This part of your score doesn’t necessarily have anything to do with your age, Kessler said, but rather how long your oldest line of credit has been in place. Even if you don’t use that line of credit often, every six months or so make a small purchase and pay it off at the end of the month.
It’s also important to avoid opening too many lines of credit or applying for multiple credit cards at one time. One credit application inquiry will not drop your score precipitously, but multiple inquiries in a short period of time can have a big impact.
Having multiple types of credit is also helpful—as long as you aren’t overburdened with debt—and will also help you raise your FICO score. A score above 760 is considered an excellent score, Hall said. In general, the best credit behavior you can establish is to pay off your balance at the end of each month.
“If you follow these rules, are responsible, pay off your credit cards each month and check your credit report once a year along with your FICO score, you’ll be in good shape,” Hall and Kessler said.