What 3 Things Are Used to Determine Your Credit Rating?

Introduction: The Foundation of Your Financial Life

Your credit rating, often referred to as your credit score, is a numerical representation of your creditworthiness. It's a key factor lenders, landlords, insurers, and even some employers use to assess the risk of extending credit or services to you. A good credit score opens doors to better interest rates on loans, easier approvals for rentals, and lower insurance premiums. Conversely, a poor credit score can lead to higher costs, limited options, and even outright denials. While many factors contribute to your overall credit health, three stand out as the most significant in determining your credit rating.

The Big Three: Understanding the Core Factors

While numerous data points are considered, the following three factors consistently weigh heavily on your credit rating:

1. Payment History
2. Amounts Owed
3. Length of Credit History

Let's delve deeper into each of these factors to understand how they impact your credit score and how you can optimize them for a better rating.

1. Payment History: The Cornerstone of Creditworthiness

Payment history is arguably the most influential factor in determining your credit score, typically accounting for about 35% of your FICO score. It reflects your ability to consistently repay your debts on time. Lenders want to see a track record of responsible borrowing and repayment, as this indicates a lower risk of default.

What's Included in Payment History?

• On-time payments: Every successful, timely payment contributes positively to your credit score.
• Late payments: Even a single late payment can negatively impact your score, especially if it's significantly delayed (e.g., 30 days or more).
• Collection accounts: Unpaid debts that are sent to collection agencies have a severe negative impact.
• Bankruptcies: Bankruptcy filings are among the most damaging items on your credit report.
• Charge-offs: When a creditor writes off a debt as uncollectible, it's reported as a charge-off and harms your credit.
• Foreclosures and Repossessions: These events signify a significant inability to manage debt and severely damage your credit.

How to Improve Your Payment History

• Set up automatic payments: Automate your minimum payments to avoid missing due dates. Consider setting up higher payments if you can afford to pay down your debt faster.
• Use calendar reminders: If you prefer manual payments, set reminders a few days before each due date.
• Contact creditors if you're struggling: If you anticipate difficulty making a payment, contact your creditor immediately. They may be able to offer temporary hardship programs or payment plans.
• Check your credit report regularly: Review your credit report for any errors or inaccuracies related to your payment history. Dispute any errors with the credit bureaus. You can get a free copy of your credit report from AnnualCreditReport.com.

The Impact of Recent Late Payments

The impact of late payments diminishes over time. However, recent late payments have a more significant effect on your credit score than older ones. Consistent on-time payments in the months following a late payment can help mitigate the damage.

2. Amounts Owed: Managing Your Debt Burden

Amounts owed, also known as credit utilization, accounts for approximately 30% of your FICO score. This factor considers the total amount of debt you owe in relation to your available credit. It's not just about the *total* amount you owe, but also *how much* of your available credit you're using.

Understanding Credit Utilization

Credit utilization is calculated by dividing your total credit card balances by your total credit card limits. For example, if you have two credit cards, one with a $5,000 limit and a $2,000 balance, and another with a $3,000 limit and a $1,000 balance, your credit utilization is ($2,000 + $1,000) / ($5,000 + $3,000) = $3,000 / $8,000 = 37.5%.

Generally, a credit utilization ratio below 30% is considered good. Ideally, you should aim for below 10% for optimal credit scoring.

Why is Credit Utilization Important?

High credit utilization suggests that you rely heavily on credit and may be at higher risk of overextending yourself. Lenders view lower credit utilization as a sign of responsible credit management.

How to Improve Your Credit Utilization

• Pay down your credit card balances: This is the most direct way to lower your credit utilization. Focus on paying down balances on cards with the highest interest rates first.
• Request a credit limit increase: Increasing your credit limit, without increasing your spending, will automatically lower your credit utilization ratio. However, be responsible and don't use the increased limit to accumulate more debt.
• Open a new credit card (with caution): Opening a new credit card can increase your overall available credit, thereby lowering your credit utilization. However, avoid opening multiple accounts in a short period, as this can negatively impact your credit. Also, only open a new card if you can manage it responsibly.
• Balance transfers: Transferring balances from high-utilization cards to low-utilization cards can improve your overall credit utilization. Be sure to check the fees associated with balance transfers.

The Impact of High Credit Utilization

Even if you make all your payments on time, high credit utilization can significantly lower your credit score. Prioritize paying down your balances to improve your score and save on interest charges.

3. Length of Credit History: Building a Credit Legacy

Length of credit history contributes approximately 15% to your FICO score. This factor reflects the age of your oldest credit account, the age of your newest credit account, and the average age of all your credit accounts. Lenders prefer to see a long and established credit history, as it provides more data points to assess your creditworthiness.

Why is Length of Credit History Important?

A longer credit history allows lenders to observe your credit behavior over an extended period, providing a more comprehensive picture of your ability to manage credit responsibly. It demonstrates a consistent pattern of either good or bad credit habits.

How to Build a Credit History (Even If You're Starting Out)

• Become an authorized user on a trusted family member's credit card: If a family member has a long-standing credit card with a good payment history, becoming an authorized user can help you build credit. Make sure the card issuer reports authorized user activity to the credit bureaus.
• Apply for a secured credit card: Secured credit cards require a security deposit, which acts as collateral. They are easier to obtain than unsecured credit cards and can help you establish credit.
• Apply for a credit-builder loan: Credit-builder loans are specifically designed to help individuals with limited or no credit history build credit. The loan proceeds are typically held in a savings account, and you make regular payments on the loan. Once the loan is repaid, you receive the funds.
• Apply for a student credit card: If you're a student, consider applying for a student credit card. These cards are often easier to obtain for students with limited credit history.

What NOT to Do to Impact Length of Credit History Negatively

• Avoid closing old credit accounts, especially those in good standing: Closing older accounts can shorten your credit history and increase your credit utilization, especially if those accounts have high credit limits.

Patience is Key

Building a credit history takes time. There are no quick fixes. Focus on establishing and maintaining responsible credit habits, and your credit score will gradually improve.

Other Factors That Influence Your Credit Score

While the three factors above are the most significant, other elements also play a role in determining your credit rating. These include:

• Credit Mix: This refers to the variety of credit accounts you have, such as credit cards, installment loans (e.g., auto loans, mortgages), and retail accounts. Having a mix of credit accounts can demonstrate your ability to manage different types of debt responsibly.
• New Credit: Opening multiple new credit accounts in a short period can negatively impact your credit score, as it suggests you may be taking on too much debt too quickly. Hard inquiries on your credit report also result from applying for credit.