The importance of a good credit score cannot be overstated. It may not seem like an important matter until you try to get a car loan, mortgage loan, rent an apartment, get utility service, or even obtain employment. When you consider all of those factors and big life decisions being lumped into one score, it's a really powerful tool that can have potentially life altering implications.
So, how do you ensure that your credit score doesn't have negative implications on your ability to achieve any of the aforementioned items? Let's take a look at the 5 Components of a credit score. Credit Scores are calculated by looking at these 5 factors in order of importance: Payment history (35%), Amounts Owed (30%), Length of Credit History (15%), Credit Mix (10%), New Credit (10%).
Payment History - You want to ensure that you are making payments in a timely matter for any debtor you owe money to that are reporting to a Credit Bureau. Examples would include Mortgage Servicers, Banks, Credit Card Companies, Store Credit Cards, Cell Phone Providers, Student Loan Companies, Medical Bills, etc. Typically reporting occurs every month and will confirm either on time payment, 30, 60, or 90 days past due. Reporting's generally stay on your credit report for seven years. If you notice any irregularities, contact the company immediately and then the three main Credit Bureaus (Transunion, Equifax, and Experian). Remember, this is the most important aspect of your credit score and you don't want a late payment adversely effecting your credit score for the next seven years.
Amounts Owed - The manner of which you utilize your credit actually plays a rather important part of how your credit score is calculated. In fact, it's 30% of the consideration. As a general rule of thumb, you want to ensure your credit utilization is not over 30% of your available credit for a particular debt (credit card, personal loan, etc.). For example, if you have a credit card with a $5,000 line, you'll want to try your best to keep your balance below $1,500. Now, you might think that is silly, considering you technically have $3,500 of remaining available credit. However, when that 30% mark is broached and as it continues to go higher (40, 50, 60%+), that's a signal to potential lenders that you may be attempting to obtain a loan or other service from, that you're high risk or potentially over extending yourself. I learned this the hard way myself, when I saw my credit score drop temporarily (about 60 points) after racking up my card over 50% utilization. I thought I would be fine as long as I paid it off each month (credit card point chaser here; guilty as charged), which was not the entire story. If you do go over 30% and your score drops one month, do not worry as it should revert back the next month when the utilization is brought back down. From that sense, it is temporary and it's a good thing. However, it's an important factor to pay attention to, especially if you're working on paying down a longstanding credit card bill for example, or are about to apply for an important credit (like a mortgage application).
Length of Credit History - We can only control this aspect so much. Ex: An 18 year old that is new to the adult world and has virtually no credit. The biggest challenge with this bracket is that some credit lines might make sense to close down, however, by closing them, your average credit history can potentially decline. In each individual case, the pros and cons need to be weighed prior to taking action (close or keep open). Also, remember that this is just 15% of your total score aspect, as apposed to the greater weight on the previously mentioned items.
Credit Mix - This aspect of your credit score will take into account your "mix" of credit, including credit cards, retail accounts, installment loans, mortgage loans, student loans, etc. I would not recommend opening various credit cards, loans, etc., just to "diversify". Do your thing and utilize credit when necessary. Remember, this is an overall small aspect of your score at just 10%.
New Credit - I'm sure many of you have heard the phrase "hard credit pull". This is where this aspect of your credit score comes in to play. While it is certainly important to not run all over town getting hard credit pulls generated on a daily basis, it's also not the end of the world if you need to do so every once in a while. There are also many misconceptions surrounding the impacts of a "hard pull" on your credit. If you're shopping mortgage rates, car loans, etc., it's okay to go to a handful of lenders and have them all pull your credit. There's generally a window of time for which this is acceptable; typically 14 days.
Now that you know the 5 factors that make up a credit score, what can you do to improve yours? My suggestion is don't worry about getting a perfect score (850). There are people out there that do that and while it's fine, it's also not all that important. Consider your own personal goals and the impact that your credit score may have on them. For instance, generally speaking a score of 740+ will give you the top tier interest rate on a mortgage and other loans. Lower scores, mean higher rates, which ultimately means more interest money owed for you in the long run.
Lastly, monitor your credit on a monthly basis. Sign up for Credit Karma, pull your free credit report from each of the three credit bureaus throughout the year and take advantage of any other free credit monitoring tools. Credit Karma for example, provides me e-mail updates anytime there is a change to my credit. I'm all over it and check to ensure that the change is something I allowed (hard credit pull, or a decrease/increase in credit utilization, etc.). By staying on top of your credit, you can avoid identity theft, or incorrect reporting data, which can negatively effect you in a multitude of ways.