Your Quick Guide to Understanding Credit
You know your credit is important. You know you have a score, and reports. But the rest is a bit of a mystery, and kind of a scary mystery at that. The good news is understanding credit doesn’t have to be mysterious or intimidating. We’re going to break down the four biggest questions everyone has.
- What impacts my credit score?
- What’s the best way to improve my score?
- What should I avoid doing?
- What are some of the most common credit myths?
One of the biggest questions people have is what exactly is it that impacts their credit score. This is important to know; you’ll want to adopt financial behaviors that lead to a stronger score. There are four main factors that will impact your score.
There are other factors that impact your score, including the number of times you’ve applied or opened new credit in the past year. Each new credit line or separate inquiry will cost you points, and those points won’t be added back to your score for 12 months from the date you opened or applied for the new credit.
- Your payment history is the number one factor that impacts your score. It’s critical to pay your bills on time. Whenever you’re 30 days late or more, your score is going to drop. Collection items from unpaid utility or medical bills can cause your score to drop significantly, as can failure to pay open credit lines (credit cards or lines of credit) on time.
- Pro-Tip: If you’re struggling to make payments, don’t just ignore it and hope it goes away. Talk to your creditors. They may be able to work out a payment plan with you, especially on items like medical bills. You can also speak to your financial institution. They will very often have solutions or suggestions to help you manage your debt.
- Capacity is another major consideration. Capacity refers to the amount of your total available revolving credit (credit cards and lines of credit) that you’re currently using. So, for example, if the total credit available to you is $10,000 and you have $5,000 in balances, your capacity is 50%. The closer you come to maxing out your capacity, the lower your score will drop. You’ll want to keep your balances as low as possible to improve capacity and demonstrate sound financial management.
- Pro-Tip: Consolidating your debt with a Personal Loan is one solution that frees up your available balance. Doing so increases your capacity and improves your score. In addition, a Personal Loan is an installment loan, which can help your mix of credit types if all you have are credit cards.
- The mix of credit items you have also impacts your credit score. A more substantial mix of items, including credit cards, auto loan, mortgage, personal loan, will help your score because it demonstrates your ability to pay several kinds of debts. This doesn’t mean you should go out and apply for a bunch of loans to diversify your credit mix. Managing your finances responsibly is still the best way to positively impact your score.
- The length of your credit history matters, too. A longer credit history can mean a higher score because it demonstrates a history of responsible credit management. So, should you close a card if you pay it off? Believe it or not, no. Even if you pay a card off, keep it open, especially if it’s a card you’ve had for a while. Closing it could actually bring your score down because it shortens your credit history.
- Pro-Tip: There are some situations in which closing a paid-off card is better than keeping it open. If, for example, you struggle to manage credit card debt and want to avoid racking up a balance again, close the card. The hit you’ll take on your credit score is better than digging yourself into a debt hole again. If you want to keep the line open and avoid using it, you can just cut or shred the card.
It may seem overwhelming to try to tackle your credit, and sometimes it’s tempting to just ignore it and hope it fixes itself. But, it won’t. Here are our top tips for how you can improve your score.
- Pay your bills on time. This is the single most important thing you can do to improve your credit. Once you’re 30 days late on a payment, your credit score will be impacted. Not paying bills on time can also start a vicious cycle of late fees and, while that may not necessarily impact your credit score, it can put you in a position of trying to play financial catch-up.
- Get a credit card if you don’t have one. There’s an old myth out there that not getting a card helps your score, but that simply isn’t true. You need to demonstrate your ability to manage revolving credit (a credit card) responsibly to boost your score. If you aren’t able to qualify for a credit card, consider researching secured credit cards to help you start building your credit.
- Use your cards, but try not to carry a balance. Yes, making on-time payments on the balance definitely helps, but paying it in full maintains a better capacity, which helps your score.
- Pro-Tip: The best way to use your card to build your credit? Use it every month, but set aside the same amount of cash in your checking account. Then, use that money to pay your credit card in full each month.
- If you have outstanding debt, attempt to resolve it. If an old bill is still haunting you, pay it off and have it removed from your credit report. Once it’s removed it does not impact your score at all.
- Try to keep a mix of credit, if possible. Having a car loan, a couple of credit cards and a mortgage is better for your score. Again, that doesn’t mean you should put yourself in a precarious financial position to open up a bunch of loans and cards, but if you can manage a good mix, it will help your score.
There are three big missteps to avoid to help keep your credit score in a good place. First, limit the number of applications you submit for credit. It can be tempting to accept every credit card offer you receive, but every time you do so an inquiry is made on your credit. Inquiries ding your score, and combined with the fact that new credit lowers the overall age of your credit history, the points you lose can last up to a year.
The next two mistakes go hand-in-hand. Don’t carry high balances on your cards for more than 30 days. It’s far better to pay off your balances than allow them to roll forward. It’s so easy to swipe and not think about the money you’re spending, but eventually that balance will be due. If you’re not able to pay it in full, carrying the balance on your card will affect your credit score. (It’s equally important to avoid maxing out your cards. Maxing out your cards put you at risk of over-the-credit-limit penalties. And, because you’re reducing your credit capacity, you’re hurting your score.) Similarly, avoid paying your bills late. Failing to make your payments on time is indicative of poor credit management and will take a toll on your score.
Understanding that not everything you hear about credit is true is just as important as understanding what impacts your score. Let’s debunk some common credit card myths.
Myth: Paying your utility bills, cell phone bill, car insurance, etc., on time will improve your score.
Fact: Your credit score reflects how well you manage money you’ve borrowed. Only credit lines that you’re borrowing against and are paying back will positively impact your score.
Pro-Tip: While paying your various bills on time doesn’t help your score, not paying them will hurt your score. It’s a one-way street.
Myth: Keeping balances on your cards is good for your score.
Fact: Paying your balance in full each month is what boosts your score. If you are unable to pay the full balance each month, work on paying it off as soon as possible.
Myth: Credit monitoring services like Credit Karma and Credit Sesame give me my credit score.
Fact: Scores that are provided by credit monitoring services are not actual FICO scores but a score that they’ve created based on your credit history. While these services are useful for giving you a general idea of what’s going on in your credit report, they can differ from your actual credit score, sometimes by quite a bit.
Using the information we’ve outlined here, you can get on top of your credit and adopt behaviors that will lead to a strong score. Remember to check your credit report from all three bureaus at least annually, and always report lost or stolen cards or fraudulent activity right away.
Download our free guide to Managing Credit Wisely for more tips!