As a young adult, strengthening your credit score is an important part of your financial strategy. So, how do you do this? Today we’ll look at the five components of a credit score and strategies to start off strong.
Factors In a Credit Score
Your credit score is reported by the 3 credit reporting agencies, TransUnion, Equifax, and Experian. While each agency calculates it’s score independently, it’s influenced by 5 factors, as reported by Experian, which are generally factored as follows:
- Payment History (35%): Paying your bills on time shows potential lenders that you can responsibly manage credit. If you manage your cash flow properly, then it should be fairly easy to earn this 35% of your credit score. Make sure you don’t let your bills go past 30-days past-due.
- Credit Usage (30%): The amount of your allowed credit you use is your credit utilization ratio. A low ratio demonstrates your ability to resist overborrowing on revolving credit (mainly credit cards). For example, if you have 2 credit cards with a combined limit of $5,000 and you regularly charge $1,000, your ratio is $1,000/$5,000 or 20%. Credit reporting agencies look for a score below 30% and those with the highest scores have ratios below 10%. Pay off your credit cards monthly to maintain a low credit usage ratio.
- Credit History (15%): Your credit history represents the how long your credit accounts have been open even if they don’t have a balance. The longer your history, the better.
- Credit Mix (10%): Credit reporting agencies like to see consumers manage 2 different types of loans. The first type, installment loans, are typically longer-term debt with regular monthly payments. Auto loans, home mortgages, and student loans are installment loans. The second type, revolving loans, are loans you can borrow and make payments against on an ongoing basis. Credit cards are revolving debt.
- New Credit (10%): Unlike the other four categories, new credit actually reduces your credit score temporarily. New credit reduces the length of your credit history. However, over time, as you make regular payments and the lengthen your credit history, your score will recover.
Improving Your Credit Score
Key strategies that increase your credit score relate to increasing the length of your credit and not over borrowing. Following are 4 key strategies:
- Pay your bills on time. If you have trouble keeping up with monthly bills, you can streamline the process by signing up for automated payments or setting a day aside each month to review and pay all recurring bills. If you auto-pay, make sure you have enough cash in your bank account to cover the bills when they are paid. Don’t be more than 30 days late paying any bills.
- Use a credit card and pay it off monthly. Adhering to your budget and keeping a sufficient cash fund will increase your ability to pay the card off monthly. Do not use this strategy if access to credit cards causes you to overspend!
- Only open credit accounts you need. We have a limited borrowing capacity, so it’s important to save that capacity for credit we actually need. As you use your credit responsibly, your borrowing capacity will increase. Stick to your budget as your credit limit increases and your credit score should go up.
- Keep unused accounts open. If you can resist borrowing against credit you’ve paid off, then keep these accounts open. This will increase your credit history. If open accounts are a temptation to over borrow, however, then it’s better to close them and take a temporary decrease in your score.
Bottom line? Rather than play the credit score game, basic strategies such as taking only the amount of credit you need, paying off credit cards monthly, and paying your bills on time will increase your credit score.
