Credit score – Do you know its importance and its components?

When we are discussing about managing personal finance , then what is the first thing that comes to your mind? Yes, I know – budgeting. It is one of the most common answers and which is true. You need to plan a suitable budget to manage your financial situation efficiently. Among other things which your need to consider, one of the most important ones is credit report and score. It is a prerequisite to have a good credit report in order to have a good credit score. In turn, it’ll help you have a good lifestyle.

Importance of credit report and score

If I ask you “How the interest rate on your loan is calculated?”. You might answer that the lender/creditor analyzes your credit record to find out your creditworthiness to decide the interest rate. Now, if I ask “On what basis your creditworthiness is assessed?”, do you know the answer? It is assessed on the basis of your credit report and score. The lender/creditor pulls out your credit score from the bureaus which is a reflection of how you’ve managed your credit in the past. And, this credit score is calculated on the basis of your credit report, which you can say is your financial report card. So, you should try to have a positive credit report in order to have a good score.

In this article, let’s focus on credit score – Its components; that is, what constitutes your credit score.

Components of a credit score

The FICO credit-scoring model is not known completely. However, there are 5 key components, which are prime factors of your score calculation, which are discussed below.

Payment history

You can say, 35% of your credit score is decided on the basis of whether or not you’ve made your payments on time. It is said that your past financial behavior can somewhat predict your future behavior. Though you should try to manage your loans equally, yet your credit score is hit more if you default on a larger amount – that is, a mortgage, in comparison to defaulting on a smaller revolving loan.

Length of credit history

About 15% of your credit score depends on this factor. It depends on the length of time you’ve opened an account and recent action on it. So, a longer credit history provides a better picture of your financial behavior. Therefore, there are chances of having a better score if your credit history is comparatively long.

Credit utilization

Your credit utilization determines 30% of your score. It means the percent of available credit which you, the debtor, have borrowed. As per FICO, you should try to have no more than 7% credit utilization ratio in order to have a good score.

Credit mix

It constitutes about 10% of your credit score. It determines whether or not you have a variety of debt. It will be in your favor if you have a mix of credit instead of managing only one type of credit – say, a mortgage loan. Statistical data reveals the fact that a person with a good mix of installment loans and credit cards usually possess less amount of risk for the lenders.

New credit

This factor also decides about 10% of your credit score. To get brownie points in this category, you shouldn’t open too many credit lines at the same time. If you open too many credit lines, then it might possess a threat to your future lenders. Experts say that people usually take out more credit when it makes better sense for them to do so or, when a person is in urgent need of it.

These are the factors which compute your score. However, there are certain misconceptions regarding the factors which many people think are valuable for credit score, but actually they’re not.

I will discuss about these factors in my later posts along with discussing about how to maintain a good credit report.

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