The world we live in today increasingly relies on credit. It is vital for individuals to build and maintain a good credit rating. To do so, a credit card is a great weapon in your arsenal from an early age. It can help you build your credit history which in turn helps determine your credit health over the span of your lifetime. In this post we are going to talk about how owning and using credit wisely, can help you build a stellar credit rating which in turn will help you conduct many of the side hustles that we talk about in other blog posts. But first let’s talk about some fundamentals.
What Exactly is a Credit Score?
A credit score is basically a measure of your spending habits and how well you are able to manage your finances. Without a credit score, no one in the world of financial institutions has any way of knowing whether to trust you with money. When you go out to purchase a house, a car, get a student or a business loan, most establishments that will give you the funds to conduct any of the aforementioned transactions, would like to see your credit score. It’s how they know whether you have good enough money management habits to be trusted with large sums of money.
The health of your credit score determines how much it will cost you to borrow. In other words, the higher your credit score, the cheaper it is for you to borrow. Similarly the reverse is also true where having a low credit score can cost you as you will be charged a higher interest rate for the amount of money you’ll borrow.
How Does the Scoring Work?
No one really knows how exactly the scoring algorithms work as different bureaus use different proprietary algorithms. But we do know the factors that are involved in the determination of the score. An on time payment history plays a great role in building a stellar credit. The number of credit lines that you have on your account are also taken into a consideration. So is credit utilization, the age of your credit accounts and the number of inquiries on your credit. What does all of that mean? We will take a deeper dive to explain these factors one by one.
On-time Payment
According to various scoring agencies, the biggest factor in determining the credit score of an individual is their on-time payment history. And rightfully so. If you think about it, this is the most reassuring aspect for the lenders. Your on-time payment percentage is calculated by taking the number of payments you have made on time and dividing it by the total number of payments that you have ever made for a particular credit line. Naturally, for this average value to be favorable, the two aspects that you can control are 1) obviously making the payments on time and 2) having more than one active credit line.
Transactions spread over a number of credit lines and paid on time will help you get close to that perfect credit score. This shows lenders that not only are you financially responsible, but you are able to take care of multiple accounts. By the same token, the age of your account also plays a role in determining your credit rating. It’s likely that the longer you hold an account, the more transactions you would have which means, if you miss one payment, it won’t impact your credit if you have hundreds of transactions as opposed to missing a payment when you only have a few transactions on your record to begin with.
A key advantage that you have as a borrower to keep up with on-time payments, is the minimum payment option. If for whatever reason you cannot afford to pay off your credit card balance in full, a minimum payment will also qualify as an on-time payment (provided it’s made on time).
Credit Utilization
As the name suggests, credit card utilization refers to the amount of credit that a user can draw from i.e. is approved for compared to the amount that they use. At any given time, your aim should be to use less than or up to 10% of the credit available to you. This shows lenders that although you have a lot of money available to borrow against, you are prudent enough to use it sparingly and carefully.
Having multiple credit cards can be handy in this instance as well. If you have multiple credit cards with high credit limits, you are able to borrow from one or two of them and keep your credit utilization under 10%. So long as you pay off your credit card bills in time, your credit management will be considered stellar and will reflect in your credit score.
Age of Open Credit Accounts
A third factor that plays an important role in the determination of your credit score, is how long your credit accounts have been established. The longer you own a credit line, the better it bodes for your credit score and overall credit health. This is why it is recommended to start building your credit history as soon as you possibly can i.e. when you turn 18. However, the key thing to note here is that your credit score looks at the ‘average’ age of your open accounts and not how long you’ve owned a particular credit line (although that helps).
To clear up any confusion, let’s use an example. Let’s say you get a credit card at the age of 18 and start building your credit history. By the time you turn 20 years old, your credit history is 2 years old. Now let’s say you qualify yourself for a line of credit, your overall credit age will now be deemed as 1 year, i.e. average of the 2 different credit instruments. This is why, on one hand having multiple lines of credit can help you build your credit history but on the other, it can make your score take short term hits and ought to make you think about opening a new credit line or even closing an older one. Overall, you should strive to keep an average credit age of over 4 years.
Total Number of Credit Lines
Having a number of credit accounts for a variety of reasons (mortgage, car loan, credit cards etc) also has an impact on your credit score. This again goes back to the point that was made earlier about gaining the trust of lenders and convincing them that you are responsible with your finances. The more trustworthy relationships that you build with various financial institutes via different credit tools, the better your credit rating and score gets. It shows the lenders that you are responsible with your spending and capable of handling multiple accounts.
Now, for the moment of truth. How many accounts should one have in order to build relations with financial institutions to help build their credit history. My recommendation is to eventually have anything above eleven accounts. Do realize that accounts aren’t just credit cards, it takes into consideration various loans, credit cards, and other means. The reason why you want to have many accounts that are paid in full each month is to showcase that you are a responsible adult that will be of little to no risk to the lender.
So how many credit lines should one have? Sites like Credit Karma suggest that it takes over 21 lines of credit to help you get a perfect score. But with all the other factors associated with opening of new credit lines (i.e. adverse impact on credit age), it is natural that applying for haphazardly doesn’t work either. Luckily, the number of credit lines is a small factor in the determination of credit scoring and as such, one should let the natural course of time and life events dictate acquisition of more credit lines.
Number of Hard Inquiries
Whenever you apply to get qualified for a new credit line, it’s considered a hard inquiry on your credit record. Each hard inquiry has a detrimental effect on your credit score as it gets knocked down by a few points. However, with time the effect is reversed as you continue to build your score via other means and hard inquiries are completely wiped after two years.
The reason why hard inquiries pull down your score is because it gives lenders a reason to pause when considering lending to you if you are going around credit shopping. It sends the message that you may either be spiraling out of control or worse, something bad has happened and as such you are trying to get as much money as possible and might default on the loans later.
Hard inquiries are basically checks on your account from a financial institution. You can expect to receive a hard inquiry when you apply for a brand new credit card, initiate a loan application etc. The impact of hard inquiries will be immediate on your credit score, however, it fades within the year and your score recovers. Also, keep in mind that while shopping for a car loan or a mortgage, you are allowed to have your credit checked by multiple lenders, provided it’s done within a short period of time, and have your credit rating only take a hit once.
In Conclusion
As we discovered, there are a number of factors involved when it comes to determining a credit score and they are all intertwined in one way or another. It is good to be aware of all these aspects that are involved in determining a credit score. That way you can make informed decisions when it comes to applying for loans, cancelling credit cards and starting to build your credit history from an early age.