Credit
Credit refers to a contractual agreement between a lender (“creditor”) and a borrower (“debtor”) whereby the borrower receives money or assets and agrees to repay the lender at a later date, usually with added interest.
Credit Score vs. Credit Report
It is important to understand that credit score and credit report are not the same thing. Credit score refers to a person’s creditworthiness (i.e. how reliable a borrower is likely to be) and is represented by a three-digit number ranging from 300 to 850. A credit report is a document that contains a detailed summary of a person’s credit history.
Understanding the difference between a credit score and a credit report is important because lenders may request one of them prior to doing any business with you. Checking your credit score is referred to as a “soft inquiry” (or “soft pull”) because checking your score does not affect you in any way. You can check this score as often as you prefer, though it typically updates once every 45 days. On the other hand, checking your credit report is referred to as a “hard inquiry” (or “hard pull”) and may negatively affect your credit score in the short term.
Components of a credit score
A credit score is a numeric number (300-850) given to a person to represent creditworthiness, i.e. how trustworthy someone is to doing business with.
A credit score may be made of several components:
On-time payment history
Credit utilization
Total credit limit
Length of credit history
Mixed accounts (e.g. mortgage, auto loans)
Number of recent credit inquiries
You may have different credit scores depending on the algorithm being used (e.g. FICO vs. VantageScore). Using the components listed above, each algorithm places a different emphasis or weight on how heavily each factor influences the credit score. Generally, the most important factors of any credit score include the following:
1. Making regular, on-time payments.
2. Maintaining a low monthly credit utilization.
A FICO credit score is a scoring model that considers different factors to determine your credit worthiness.
VantageScore is a credit score algorithm that was created by three credit bureaus--TransUnion, Experian, and Equifax. VantageScore is a competitor to FICO Score.
What is credit utilization?
Credit utilization is represented by a percentage. Credit utilization is the amount you spend in a month divided by the total credit limit of all your combined credit cards (hence, total credit utilization).
For example, if I spend $100 and my total credit limit is $1000, my total credit utilization would be 0.10, or 10% ([$100/$1000] * 100 percent = 10%).
Please note that the credit utilization that you have for each individual credit card also matters in determining your credit score. This is referred to as per card credit utilization. So, if credit card A has a 75% utilization but your overall utilization is 5%, it would be wise to lower credit card A’s utilization prior to the close date (“close date” is discussed below).
Why should you care about your credit score?
Credit lenders will often ask for your credit score prior to approving you for loans, credit cards, apartments, cell phone plans, and more. If your credit score is poor, a lender may deny you from receiving a loan or service. Even if you happen to get approved for a loan or service with a poor or mediocre credit score, the interest rate offered to you may increase (i.e. with a poor credit score, you will pay more than what you would have paid if you had a higher credit score).
How do you increase your credit score quickly?
Below are the different components of a credit score (reproduced from earlier) but with additional elaboration on healthy practices.
On-time payment history (heavily weighted)
Never miss a payment. Ever.
Setup autopay.
Credit utilization (heavily weighted)
Maintain a per-card credit utilization of about 1% (ideally less than 10% at the highest).
Maintain a total credit utilization of about 1% (less than 10% at the highest).
Total credit limit
Having a high credit limit across all your credit cards makes it easier to maintain a lower credit utilization. However, a high total credit limit is unnecessary for a high credit score.
Length of credit history (“average age of credit”)
The longer your credit history the better. If you can manage good habits, open a “no-annual-fee” credit card as early as possible.
The “average age of credit” refers to the average length of time all of your accounts have been open. Having a long average age of credit may help your credit score.
Mixed accounts (e.g. mortgage, auto loans)
Having a mix of different accounts
Number of recent credit inquiries
The lower the number the credit inquiries the better
