When starting out your business or when you are pressed financially, getting credit might be a good option for you to raise some cash to solve some of the problems.
However some important factors might affect a lenders willingness to give you credit. This means that your credit score will surely be considered by a lender when you request for credit. But what is a credit score and how can you increase it to get more credit?
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This article will focus on what a credit score is, how to improve it and what factors can really affect your credit score. These points will stand out:
- What is a Credit Score
- What factors can Affect your Credit Score
- How to build your Credit
What is a Credit Score
A credit score is a number that lenders use to determine the risk of loaning money to a given borrower.
Credit card companies, auto dealers, and mortgage bankers are three types of lenders that will check your credit score before deciding how much they are willing to loan you and at what interest rate.
Insurance companies, landlords, and employers may also look at your credit score to see how financially responsible you are before issuing an insurance policy, renting out an apartment, or offering you a job.
What factors can Affect your Credit Score
Your credit score shows whether or not you have a history of financial stability and responsible credit management. The score can range from 300 to 850.
Based on the information in your credit file, major credit agencies compile this score, also known as the FICO score.
Here are the elements that make up your score and how much weight each aspect carries.
Your Payment History
There is one key question lenders have on their minds when they give someone money: “Will I get it back?”
The most important component of your credit score looks at whether you can be trusted to repay funds that are loaned to you. This component of your score considers the following factors:
- Have you paid your bills on time for each account on your credit report? Paying late has a negative effect on your score.
- If you’ve paid late, how late were you—30 days, 60 days or 90+ days? The later you are, the worse it is for your score.
- Have any of your accounts been sent to collections? This is a red flag to potential lenders that you might not pay them back.
- Do you have any charge offs, debt settlements, bankruptcies, foreclosures, lawsuits, wage garnishments or attachments, liens or public judgments against you? These items of public record constitute the most dangerous marks to have on your credit report from a lender’s perspective.
- The time since the last negative event and the frequency of missed payments affect the credit score deduction. Someone who missed several credit card payments five years ago, for example, will be seen as less of a risk than a person who missed one big payment this year.
Your Level of Debt Matters
So you might make all your payments on time, but what if you’re about to reach a breaking point?
FICO scoring considers your credit utilization ratio, which measures how much debt you have compared to your available credit limits. This second-most important component looks at the following factors:
- How much of your total available credit have you used? Don’t assume you have to have a $0 balance on your accounts to score high marks here. Less is better, but owing a little bit can be better than owing nothing at all because lenders want to see that if you borrow money, you are responsible and financially stable enough to pay it back.
- How much do you owe on specific types of accounts, such as a mortgage, auto loans, credit cards, and installment accounts? Credit scoring software likes to see that you have a mix of different types of credit and that you manage them all responsibly.
- How much do you owe in total and how much do you owe compared to the original amount on installment accounts? Again, less is better. Someone who has a balance of $50 on a credit card with a $500 limit, for instance, will seem more responsible than someone who owes $8,000 on a credit card with a $10,000 limit.
Types of Credit on Your Report
Two basic types of credit accounts exist, revolving accounts and installment loans. Having both types of accounts on your credit report is better for your credit score because it indicates you have experience managing various types of credit.
It’s even better if you have loans for different types of assets, such as a car or a home, in addition to credit cards, and maybe a student or personal loan.
However, the types of credit only constitute 10% of your credit score, so not having a certain type of credit, such as an installment loan, won’t devastate your score.
However, the types of credit only constitute 10% of your credit score, so not having a certain type of credit, such as an installment loan, won’t devastate your score.
Number of Credit Inquiries
Each time you submit an application that requires a credit check, an inquiry is placed on your credit report showing that you’ve made a credit-based application. Inquiries make up 10% of your credit score.
One or two inquiries won’t hurt much, but several inquiries, especially within a short period of time can cost you many points off of your FICO score. Keep your applications to a minimum to preserve your credit score.
The good news is that only those inquiries made within the last 12 months factor into your credit score. Inquiries completely disappear from your credit report after 24 months.
Note that checking your own credit report results in a “soft” inquiry, which does not affect your credit score.
Factors that will not Affect your Credit
Some factors are commonly thought to influence your credit score, but they don’t—not directly at least.
Information like income, bank balances, and employment status can influence your ability to get approved, but they don’t actually factor into the algorithm that calculates your credit score.
Age, marital status, and debit or prepaid card usage also do not influence your credit score.
How to build your Credit
Avoid New Credit Card Purchases
New credit card purchases will raise your credit utilization rate—a ratio of your credit card balances to their respective credit limits that makes up 30% of your credit score.
You can calculate it by dividing what you owe by your credit limit. The higher your balances are, the higher your credit utilization is, and the more your credit score may be negatively affected.
Under the FICO score model, it’s best to keep your credit utilization rate below 30%. That is, you should maintain a balance of no more than $3,000 on a credit card with a limit of $10,000.
To meet that 30% target, pay cash for purchases instead of putting them on your credit card to minimize the impact on your credit utilization rate. Even better, avoid the purchase completely.
Pay off Past-Due Balances
Your payment history makes up 35% of your credit score, which makes it the most important determinant of your credit.8 The further behind you are on your payments, the more it hurts your credit score.
Once you’ve curbed new credit card spending, use the savings to get caught up on your credit card payments before they are charged off (the grantor closed off the account to future use) or sent to a collections agency.1
Do your best to pay outstanding balances in full; the lender will then update the account status to “paid in full,” which will reflect more favorably on your credit than an unpaid account. In addition, continuing to carry a balance as you slowly pay off an account over time will subject you to continued finance charges.
In addition, continuing to carry a balance as you slowly pay off an account over time will subject you to continued finance charges.
Get a Copy of Your Credit Reports
Before you can figure out how to increase your credit score, you have to know what score you’re starting from. Since your credit score is based on the information in your credit report, the first place you should go to improve your credit score is your credit report.
A credit report is a record of your repayment history, debt, and credit management. It may also contain information about your accounts that have gone to collections and any repossessions or bankruptcies.
Order copies of your credit reports from each of the three major credit bureaus to identify the accounts that need work. You can get free copies of your credit reports every 12 months from each of the major bureaus through AnnualCreditReport.com
Dispute Credit Report Errors
Under the Fair Credit Reporting Act, you have the right to an accurate credit report. This right allows you to dispute credit report errors by writing to the relevant credit bureau, which must investigate the dispute within 30 days.
Errors, which can stem from data entry snafus by creditors, easily interchangeable Social Security numbers, birthdays, or addresses, or identity theft, can all hurt your credit score.
For example, if you already have a history of late payments, an inaccurately reported late payment on the report of someone could have a dramatic and fairly immediate negative impact on your score because late payments represent 35% of your credit score. The sooner you dispute and get errors resolved, the sooner you can start to increase your credit score.
Leave Accounts Open
It’s rare that closing a credit card will improve your credit score. At the very least, before you close an account, ensure that it won’t negatively affect your credit.
You might be tempted to close credit card accounts that have become delinquent (past due), but the outstanding amount due will still up on your credit report until you pay it off. It’s preferable to leave the account open and pay it down every on time each month.1
Even if your card has a zero balance, closing it can still hurt your credit score because credit history length makes up 15% of your credit score.
Credit history length factors in the age of your oldest account and most recent account as well as the average age of all accounts. In general, the longer you keep accounts open, the more your credit score will increase.
Avoid New Credit Card Applications
As long as you’re in credit repair mode, avoid making any new applications for credit. When do apply for new credit, the lender will often perform a “hard inquiry,” which is a review of your credit that shows up on your credit report and impacts your credit score.
How many credit accounts you recently opened and the number of hard inquiries you incurred both reflect your level of risk as a borrower, so they make up 10% of your credit score.
Opening many accounts over a relatively short period can be a red flag to lenders that a borrower is in dire financial straits, so it can further decrease your score.
In contrast, having few or no recently opened accounts indicates financial stability, which can boost your credit score
Pay off Debt
Your amount of debt that you’re carrying as a proportion of your overall credit represents 30% of your credit score, so you’ll have to start paying down that debt to raise your credit.
If you have a positive cash flow, meaning you earn more than you owe, consider two common methods for paying down debt: the debt avalanche method and the debt snowball method.
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With the avalanche method, you first pay off the credit card with the highest APR with your extra money. Make minimum payments on other cards, and use any leftover funds toward the high-interest card. When you pay off that card, move to the next-highest APR card and repeat.
The snowball method requires you to make minimum payments on every card, every month. You then use any extra funds to pay down the card with the lowest balance.
Once that one is paid off, apply extra money to the card with the next lowest balance, but continue to make minimum payments on the other cards.
If, however, you owe more than you make, you’ll need to get creative about coming up with the extra money you need to pay off your debt.
For example, you could drive for a ride-sharing service or sell some things on an online auction website for extra cash. It will take some sacrifice, but the financial freedom and the credit score points you’ll gain will be worth it.
While your credit score is extremely important in getting approved for loans and getting the best interest rates, you don’t need to obsess over the scoring guidelines to have the kind of score that lenders want to see. In general, if you manage your credit responsibly, your score will shine.
