What Is a Credit Score and How Do I Improve Mine?

Your credit score plays a factor in determining everything from whether you qualify for a home or car loan, what your car insurance rate will be, and sometimes whether you’ll get a job or apartment for which you’re applying. 

So, what is a credit score, exactly? 

If you’re going to loan someone money, you want to have a good idea of whether they’re able to pay it back, right?  You’re going to be hesitant about loaning money to your co-worker who always borrows just a few bucks for the weekend, promises to have it back to you by Monday, but somehow never does. 

When you apply for a loan, the bank doesn’t have the benefit of knowing you personally. So, instead of calling your mom to see how responsible you are, they look to your credit score to get an understanding of how likely you are to pay them back. 

Credit scores are an imperfect way of measuring the likelihood you will repay your debt. Having a bad credit score doesn’t necessarily make you irresponsible, and it certainly does not mean you are a bad person.  However, having a good credit score makes things like loans and car insurance less expensive and will likely play a factor in deciding things like whether you qualify for a home loan, so it’s worth it to improve your score.   

The good news?  There’s a trick to having a good credit score, and you can learn to manage your credit.    

Factors That Make up Your Credit Score:

1.  Payment History (35%) – This refers to the percentage of payments you make on time. The higher the percentage, the better your score (surprise surprise).  

2.  Credit Card Utilization Rate (30%) – Credit-scoring companies consider it a good sign when you have more credit available than you’re actually using.  For instance, if your credit card has a $5,000 limit, your credit score will be better if you have a balance of $520 compared to a balance of $4,980.  A good rule of thumb is to use less than 30% of your available credit (so, less than $1,500 in our example).

3.  Length of Credit History (15%) – This is the one I see my younger clients struggle with the most.  Credit-score companies want to know how long you’ve had your accounts open, and the longer your history the better.

4. Types of Credit (10%) – This takes into account your mix of different types of accounts, for example, a credit card and a mortgage or car loan.  Credit Companies like to see different types of credit (for example a mortgage and a credit card).  

5. Number of Applications for New Credit (10%) – Lenders are less excited about giving you a car loan if in the last six months you’ve also applied for a home loan, a new credit card, and a personal loan. They worry that taking out a lot of different lines of credit in a short amount of time will increase the likelihood that you won’t be able to pay back what you borrow. 

Improving Your Credit Score 

Okay, so if your credit is largely determined by how much money you borrow and how reliable you've been in the past when it comes to making payments, what can you do to improve your credit?  Try taking these steps: 

1.  Make payments on time.  Set up your payments to automatically come out of your bank account to make sure you don’t forget.  Try to never "skip" a payment.

2. Stay well below your credit limit.  Pay off your credit cards regularly, at least once a month, and try not to have more than 30% of your limit on your credit card at any one time.  If you have a low limit (like $1,000), consider requesting a credit increase so you don’t get thrown off by one larger purchase. 

3. Decide if you trust yourself with a credit card, and establish credit early.  I am not suggesting everyone go out and get a credit card with a high credit limit.  Never take out credit if you don’t trust yourself to pay the full amount off on time every month.  A good credit score is not worth credit card debt.  Do some soul-searching to decide whether or not you really trust yourself with a credit card. 

If you don’t think you’ll handle credit well, know that things like student loans and car loans are also considered credit and will likely help you establish a history. 

Another thing to consider is getting a credit card with a low limit, setting up an automatic payment on it, paying it off every month, and not carrying the credit card with you. For example, I have clients who have a credit card with a $1,000 limit.  They set their Netflix subscription to automatically be drawn from their credit card every month, and they automatically pay it off every month from their checking account.  They don’t carry the card with them or use it for any purpose other than their automated payment.    

4. Track your credit score, and make sure there’s not anything on there that shouldn’t be.  Use a site like www.CreditKarma.com to keep an eye on your credit score, see what factors are most affecting you, and identify steps you can take to improve your score.

Make sure you recognize everything affecting your score.  It’s not uncommon for there to be errors on a credit report, and when that happens, be sure to report them and get them cleared. You don’t want to have a bad credit score because of something you didn’t even do. 

5.  Don’t get discouraged.  Credit scores are not permanent; they can be improved.  Take the steps to repair your credit as soon as possible; you’ll be surprised at how small changes can improve your score in a relatively short amount of time.

6.  Don’t wait until you need credit to work on improving it.  Even if you don’t need to use credit in the near future, you want to have a grasp of how you’re doing and start taking steps to improve your score.  Having a good credit score is very possible, but it takes time. Take the steps to improve your credit score now so when you decide you want to buy a house or need your own car insurance, you’re prepared to get a good rate. 

About the Author

Stephanie (Custer) Vail is a member of the LPL Custer Financial Advisors team.  She lives in Grand Rapids, Michigan and specializes in helping millennials with financial literacy and financial planning.  To learn more about Stephanie and Custer Financial Advisors, visit www.CusterFinancialAdvisors.Com or email Stephanie at SVail@lpl.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. For advice specific to your situation, please contact us.