Credit scores have become more important than ever. Not only do financial institutions use credit scores in evaluating whether they'll give you a mortgage loan, auto loan, credit card, or other types of credit, but landlords, insurance companies, and even employers will often check your credit history to make decisions that can affect your financial life and your career.
With that in mind, it's essential to understand the secrets behind the credit score and what you can do to improve it. Below, we'll go through the five factors that go into credit scores, and how you can make the most of them.
1. Make your payments on time.
Payment history makes up 35% of the mechanism that Fair Isaac (NYSE:FICO), inventor of the FICO score, uses to determine your creditworthiness. The company considers credit cards, retail store accounts, and installment loans like car loans, as well as accounts through finance companies and any mortgage loans you have.
In looking at late payments, FICO considers how late they were, how much was owed, how recent they were, and how many times you were late. A single mistake won't crush your score, but repeated offenses can add up quickly. In addition, bankruptcies, foreclosures, lawsuits, wage attachments, liens, and adverse judgments will count against your score.
The best way to get this score up is to make sure you make payments on time. The longer you go with a better track record, the more your score will rise.
2. Make sure the amount you owe is manageable compared to how much credit you have.
Another key aspect of your score is the amount you owe, which is responsible for 30% of your overall score. It's important to understand, though, that what credit scoring agencies look for isn't necessarily the total amount of debt, but rather how much of your available credit you've used. Also, a high number of accounts with amounts outstanding can be a danger sign.
For instance, say one person has a credit limit of $2,000 on a credit card, while another person has a $20,000 credit limit. If both people have a $1,500 outstanding balance, the impact on the first person's credit will be larger, because $1,500 represents 75% of the total available credit. By contrast, for the second person, the $1,500 balance is only 7.5% of the credit limit, making it clear that the outstanding balance isn't leaving the second person potentially overextended on debt.
3. Let time work in your favor.
About 15% of your credit score is determined by the length of credit history you have. The age of your oldest account is important, as is the average age of all of your accounts. In general, the longer the history, the better your score will be. In addition, your score will depend on the regular use of some of those accounts.
Obviously, there's nothing you can do to lengthen your credit history, but there are steps you can take to preserve whatever history you have. Before you cancel a long-held credit card, think about its impact on your score, and consider holding onto your oldest credit card. That way, you won't suffer an immediate drop in length of credit history that could push your score lower.
4. Be diversified in your credit use.
The mix of credit that you use has about a 10% influence on your credit score. If all of your debt is in one type of loan, whether it's mortgage debt or a credit card, then your score won't be as strong as if you have different types of accounts.
FICO points out that you shouldn't open accounts that you don't intend to use just to influence this factor. However, it does highlight the importance of being smart about your credit in all aspects of your financial life. If you manage multiple types of credit well, you'll be rewarded with a higher score.
5. Avoid getting lots of new credit accounts.
Finally, 10% of your score comes from the number of credit accounts you've opened recently. FICO looks back a year in determining this portion of your score, but inquiries to your credit history remain on your file for two years.
In order to avoid hits to your credit score, try not to apply for multiple types of credit within short periods of time. If you have to, try to let some time pass between each application. That way, you won't trigger alarm bells for lenders nervous about why you're trying to borrow so much right away.
Taking steps to improve your credit score can have dramatic positive impacts on your life. By knowing what goes into your credit score, you can do what you can to ensure your score is as high as possible.
Editor's note: A previous version of this article incorrectly stated that employers could gain direct access to your credit score. The credit reports to which employers and certain other inquiring parties have access are different from credit scores. The author and the Fool regret the error.
Dan Caplinger has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.