How Does Credit Work?
If you've ever applied for any type of financing whether it was your home mortgage or a business loan, you know that your credit score is a very important number. However, how your score is calculated seems to be a mystery.
What is a credit score?
Your credit score is basically a measure of your financial responsibility aka how likely you will repay your debt. Some people view it as a financial background check because credit reports display a person's credit files based on their history. The higher the score, the better your chances of securing capital at a low rate.
A good credit score can significantly impact the offer you receive when borrowing money. When you finance something with bad credit, it is significantly more expensive and may even become a liability instead of an asset. Credit helps you buy a home or rent an apartment since many owners and banks will check credit.
How do I find out my credit score?
There are many sites that help you get a sense of your current credit score:
As you probably have seen on TV or banner ads, Credit Karma gives you free credit reports for Equifax and Transunion.
Free Credit Report gives you a free credit report for Experian.
While these are only two sites out of hundreds on the internet available to obtain your credit reports, they cover all of the major credit reporting companies.
How is my credit score calculated?
While it's easy to state that defaulting on a loan will drop your credit and making consistent payments on a mortgage will increase it, there are several factors that come into play when determining your credit score.
Payment history - This is determined by your consistency in paying your debts on time. If you have frequent late payments, you can be sure that your credit score has been negatively impacted.
Amounts owed - The more money you owe and are paying back, the stronger your credit score will be. Taking out a mortgage on a $300,000 house and paying it on time will strengthen your credit score much more than a credit card with a $3000 limit.
Length of Credit History - Even if you have the largest credit lines and have been paying everything ahead of time, you might still have a lower credit score because of your history. Your propensity to default is essentially measured by "we will see" and only time will tell.
Credit Mix - It is more advantageous for your credit score to be making payments to multiple lines of credit at a smaller amount than just one large monthly sum. Referencing back to the housing example, if Person A has a monthly mortgage payment vs Person B whose total payments are less than Person A's, Person B will still have the better score. Making lease payments on a car, paying the balance on multiple credit cards, and paying back your student loans on time will raise your credit score more than a single monthly payments on a house. The reason? Multiple lines of credit demonstrates that you have willing lenders from multiple sources and you are paying them all back on time.
New Credit - Opening new credit lines will have negative impacts on your score in the short term but can help your score grow in the long run, especially if it helps add diversity to your credit mix. If you already have a car loan and you acquire your first credit card, it will improve your score because it diversifies your credit profile.
How can I improve my credit score?
There are plenty of online resources that outline how to improve your credit score. One credit reporting agency, Experian has put together an overview on how to improve your credit. But you could also consider a credit repair agency, which usually charge a modest fee (~$100 per month) to help dispute credit items and form strategies to help boost your credit.