Credit scores are increasingly critical to the financial lives of most people. They are used by insurance companies to determine premiums and even by landlords to evaluate applicants. Employers review credit information as well. Therefore, it’s important to know what affects the score.
These scores were designed to help lenders gauge a borrower’s risk of default. That’s it. The only information used is what’s in your credit report. The formula is particularly affected by:
Whether you pay your bills on time (Some utility bills too)
How much of your available credit you’re using
How long you’ve had credit
How recently you’ve opened a new account
The mix of credit in use (revolving credit vs. secured with collateral)
Medical Bills if they have been sent to collection (can disappear if insurance does come through and pay)
Here’s what does not go into a score:
Your income or how much of it goes to pay debt
Your net worth
Your retirement account balances
Your investment returns
Your employment history or prospects
Whether you live within your means
The bottom line: If you don’t have and regularly use credit, the credit-scoring algorithm formula will have a tough time assessing your creditworthiness. That’s how folks who’ve paid for everything with cash wind up with low scores or no scores. Credit scores were never designed to be an indicator of your overall financial well-being.
It’s also how people who don’t carry balances can score lower than they deserve. If they use up most of their available credit each month that can ding their scores even if they pay their bills in full. Savvy credit users continue to pay their balances, but make sure they use only a fraction of their available credit at any given time: 30% is good, under 10% is best.
Protecting your Credit Score
The formula for determining credit scores, which banks use to decide whether to give you a mortgage or any other loan, looks at something called your “utilization ratio,” the total amount of credit you use vs. the amount you have available. If you have $25,000 worth of available credit and you put $5,000 on your cards every month, your utilization ratio is a healthy, hey-I’m-living-within-my-means 20%. But cut down that credit line to $10,000 and suddenly your ratio jumps to 50%, making you look pretty overextended.
In the past, banks limiting credit lines was a measure usually reserved for more irresponsible card holders (being an irresponsible cardholder and having a low credit score usually go hand in hand). Now, even those who up till now have been responsible are being affected due to lower credit limits and higher utilization ratios.
To combat the effects. here’s what to do:
When you receive notification of higher APRs, lowered limits or annual fees, be prepared to call the credit card company and do what you can to try to get back what they have taken away from you.
Be Careful When Canceling
Do NOT cancel your major bank card just because they’ve added an annual fee. Canceling your credit card can seriously damage your credit score. If you’ve had the card for 5 or more years and cancel it, then your longevity is affected in your credit scoring. So be strategic in what you cancel and when.
Know Your Terms
It has always been essential to read and understand the terms and conditions of your contract. If you don’t understand any of the terms or conditions, call your credit card company and have them explain it to you.
With the reduction of reward perks and cash back savings, it may be time to look outside your own credit card for rewards on the items you purchase. Be sure to research (now and in the future) competing companies for the best rates, terms, rewards, and points.