The Most Important Credit Score Factors
Building and maintaining a strong credit score is important for a number of reasons. As we progress through adulthood, our borrowing needs tend to intensify – for instance, a recent college graduate isn’t likely to immediately pursue a home mortgage following graduation, though pursuing a low-limit unsecured credit card at that time is quite likely.
However, as the years go by, it becomes far more probable that an individual who has been developing a credit history (through responsible repayment of unsecured credit card debt, among other things) very well may pursue a home mortgage or auto loan. Gaining access to these “larger-ticket” loans becomes more important with time, and a strong credit score helps facilitate the borrowing process and makes life easier.
Therefore, it is important to understand what exactly goes into formulating a credit score – what are the most important credit score factors? Let’s take a closer look.
The single most important contributing factor to a credit score is an individual’s payment history. Whenever someone is looking to establish or strengthen credit, it’s absolutely essential to establish a track record of consistent monthly payments. This only makes sense.
When a potential creditor is faced with a lending decision, that creditor seek a reliable debtor – someone who can be counted on to pay back the money owed. For this reason, FICO credit scores assign a 35% weighting to an individual’s track record of repayment while penalizing for late and missed payments, taking into account the frequency and recency of both.
The easiest way to make this contributing factor work for you? Pay your bills on time each month – no exceptions. It may sound surprising, but just one missed payment can impact a credit score by as much as fifty points.
Credit Utilization Ratio
Running a close second to payment history is credit utilization ratio, which is the overall percentage of total available credit that is actually indebted. For example, someone holding a credit card with a $10,000 credit line and an outstanding balance of $1,500 demonstrates a 15% credit utilization ratio on that specific account.
If that account is the only debt instrument in an individual’s credit profile, the overall credit utilization ratio is 15%. However, except for those individuals who are just getting started with the process of establishing and building credit, most people have more than one potential source of borrowing.
Therefore, there are two levers to consider when thinking about credit utilization ratio – the total amount of all credit lines available from credit cards, installment loans, as well as a home mortgage and/or auto loan – and the total amount of indebtedness. A lower credit utilization ratio is better – somewhere under 30% in considered favorable.
Higher than that and the credit score starts to take a hit – as the credit utilization ratio is a 30% contributing factor toward a FICO credit score.
The Two Most Important Credit Score Factors
If we were to just stop here, it’s important to realize that payment history and credit utilization ratio are the two most important credit score factors, and that together they contribute approximately 65% toward the formulation of a FICO credit score.
Perform poorly on either of these and your chances of an excellent FICO score in the 700s or higher become severely compromised. However, the reverse is also true. Make consistent timely payments while keeping your credit lines open and your balances at a minimum and you’ll be well on your way to a strong credit score.
However, there are a few more credit score factors to be aware of that can seal the deal toward a strong credit score.
Length of Credit History
The third most important credit score factor is length of credit history, which can be assessed as the average age of existing accounts. This is important to potential lenders because the longer the credit history, the greater the amount of information related to repayment and general financial behavior that can be relied upon.
Accordingly, it is wise to keep older accounts open, even when they haven’t been utilized for some time. The benefits here are actually twofold – maintaining old accounts that aren’t active also keeps the aggregate available credit higher, thereby lowering the credit utilization ratio while keeping the average age of accounts higher.
In contrast, it can hurt a credit score to close an old account in favor of a newer one, as this will shorten the credit history length. If the new account has favorable features that the older one lacks, keep the old account open and preserve your credit history length, which is a contributing factor to the tune of 15% of an overall credit score.
Diversification and Recent Credit Inquiries
The final two credit score factors each check in at 10% apiece – diversification and the frequency/amount of recent credit inquiries. While neither of these will make or break a credit score outright, they each are eligible to serve as icing on the cake for a strong credit score.
As a general rule, lenders like to see borrowing behavior that includes a variety of debt that is paid back in a timely manner – credit cards, an auto loan, personal installment loan, home mortgage, student loans, etc.
The greater the diversification, the better. Meantime, when an individual applies for credit, potential lenders perform a “hard pull” of a credit report, and this gets reported to the credit bureaus.
When an abundance of new credit is opened within a short period of time, it looks bad to lenders because it can imply desperation. FICO will look at the frequency of hard pulls over the previous twelve months and factor this into its calculation of a credit score.
Some good news – multiple inquiries related to an auto loan or mortgage are generally treated as one inquiry, since it is considered advisable to shop around for the best loan.
Additionally, when the search for the right loan is successful, available credit goes up causing the credit utilization ratio to drop, and this offsets any negative impact to the credit score from the inquiry.
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