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What is credit score and how to get started improving it

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Your credit score is simply a number that lenders assign to you to determine your capacity to repay a loan, or any line of credit.

So, if you want to get a better loan, with better interest rates, you need to have a better credit score.

To do this, it helps to know what your credit score is in the first place.

Don’t worry if you don’t know your credit score.

According to the CFPB, only 20% of people know their credit score.

To understand your credit score, you should use each of the three main bureaus (Equifax, Experian and TransUnion) for several months before you apply for credit:

Get Your Credit Score From Each of the Major Bureaus:

What Makes a Good Credit Score?

Credit scores are made up of:

  • 35% – Payment History
  • 30% – Amounts Owed
  • 15% – History Length
  • 10% – New Credit
  • 10% – Types Of Credit

1. Payment History

Payment history makes up more of your credit score than anything else. Payment history is whether your credit repayments have been made on time.

This is considered for:

  • Credit cards
  • Retail accounts (e.g. store cards)
  • Loans where you make regular repayments (e.g. car loans)
  • Mortgage loans
  • Bankruptcies can appear on your credit report for between 7 and 10 years

If you are late with a payment, this will stay on your record. This will negatively affect you credit rating. The amount it affects your rating depends upon:

  • How late the payment was
  • How much was the late payment for
  • How recently the late payments occurred
  • How many late payments there were

2. Amounts Owed

30% of your credit score is based upon the amount of debt that you owe. But, it’s not quite as simple as that.

Just because you owe a large amount of money, doesn’t necessarily mean you have a poor credit rating.

What’s a better indicator is the percentage of the available credit that has been used. For example, if you have credit of $10,000 available to you, and you have used $9,000 of that, you’re unlikely to get additional credit card or loan.

That’s because it suggested that you may be overextended and struggle to pay back what you owe on time.

The percentage of your available credit you have used is known as your Credit Utilization Ratio.

3. History Length

The length of your credit history makes up 10% of someone’s credit score.

If you have never had credit before, the lenders do not know if they can trust you to repay the money borrowed or not.

That’s why you need to have an established credit history to get better interest rates, and access to the best credit cards.

4. New Credit

How regularly you open new credit accounts makes up 10% of your credit score.

Lenders believe opening several accounts within in a short period of time can be an indicator of risk. This is especially true if the applicant doesn’t have a long credit history.

As such, simply making an enquiry can have an impact on your credit score. Although, this impact is not too great, as the ratings agencies understand people do this to find out which cards and loans can offer the best possible rates.

You really just need to be sure you are leaving space between opening multiple accounts.

5. Types of Credit

The final 10% of your credit score takes into account the different types of credit you have, or have had in the past.

This looks at:

  • Credit cards
  • Retail accounts
  • Installment loans
  • Mortgage loans

They are basically looking to see if you have had experience with this type of credit before, and have a good record of paying it back in time.

What Effect Does Poor Credit Have on Interest Payments?

As you can see from the image below, the better your credit is, the lower your interest rates are.

Just by looking at the interest rates on auto-loans, you can see the difference having excellent credit makes, when compared to poor credit.

So, on a 5-year auto-loan of $25,000:

  • Poor credit pays a total of $38,828
  • Excellent credit pays a total of $28,375

That’s a difference of over $10,000. Or, over $2,000 per year.

Now, imagine that in the context of mortgage loan worth $200,000. The difference is insane!

Not to mention, when you have better credit, you get access to credit cards that offer great rewards schemes.

Some Simple Steps to Improve Your Credit Score

1. Pay All Accounts on Time

When you charge something to your credit card, there is a grace period where you can pay off the amount you owe without being charged any interest. This grace period usually lasts 20-25 days.

But, what some people don’t know is that most credit cards come with a minimum required payment.

You see, you don’t need to pay off the full amount you owe every month if you don’t want to (we recommend you do, however.) But, you do have to pay off at least some of that amount.

If you don’t pay at least this minimum amount each month it’s known as a late payment. This will be recorded on your credit report and negatively affect your credit score.

2. Review and Dispute all Adverse Accounts

Any adverse items on your credit report can stick with you. Do what you can to remove them.

This might mean working with the individual lenders to come to an agreement to remove them.

Under the Fair Credit Reporting Act, creditors have 30 days to respond to your dispute. If you don’t get a response within 30 days they need to remove the disputed item from your credit report.

3. Don’t Apply For Loans or Credit Until You Know Your Credit Score

Making an enquiry for additional credit can lower your credit score. So, it’s important to know your credit score before you apply.

Make sure you sign up with each of the three major bureaus (Experian, Equifax and TransUnion.)

Your score is most likely either the median, or the average of the three score. Be sure to pay attention to your credit score for three months before you apply.

Know the minimum required credit score for any credit line you are going to apply for. Make sure your score is comfortably above this minimum limit.

4. Pay Your Credit Utilization Ratio Down to 30%

Credit Utilization Ratio is the percentage of the total credit available to you, that you have used.

Say you have $5,000 credit limit combined across all your credit cards. If you have used all $5,000, your credit utilization ratio would be 100%.

If you have used $500, your credit utilization ratio would be 10%.

Ideally, you want to have your overall credit utilization ratio below 30%. This indicates that you have the capacity to pay back the debt that you owe. If your ratio is in the 70%+ bracket, it suggests to lenders you have over extended yourself, and might struggle to pay back any additional credit.

If you do have a high credit utilization ratio and want to reduce it, it can make sense to take out a personal loan to pay down your credit card debt. These loans can often be taken at lower interest rates, and don’t count towards your credit utilization rate. 

So, if you transfer the balance of your credit cards to this personal loan you can reduce your credit score, by lowering your credit utilization ratio.

5. Request Credit Line Increases

Once your credit score has reached fair (580 to 669), request increases to your existing credit limits.

If you have shown a willing to work hard, and make repayments on time, this will likely be accepted. This will decrease your credit utilization ratio by increasing your overall credit limit.

This should help improve your credit score further.

You can usually request credit line increases on your lender’s website within a couple of minutes.

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