When your bank tells you that your credit score isn’t high enough to support the loan you applied for, you may scratch your head and wonder what went wrong.
The last time you checked your score it was in great condition and now you’re being denied a loan. You go to check your credit score and it turns out that your score has dropped by over 50 points!
In this article, you will become familiar with the factors that impact your credit score. Once you know the reasoning behind a huge drop in your credit score, you can assess the situation, make changes, and get right back on track.
Understanding the Difference Between Your Credit Report and Your Credit Score
Your credit score is affected by many different things, most of which reflect your financial responsibility. There are three credit reporting agencies in the United States: Experian, Equifax, and TransUnion.
They are commonly known as Credit Reporting Agencies (CRAs) and are bound by certain rules governed by the Federal Trade Commission (FTC) and the Consumer Financial Protection Bureau (CFPB). The Credit Reporting Agencies, or Credit Bureaus, gather data about you and how you use credit to form a credit report. Your credit scores are based on what’s found in the report.
There are two main organizations that look at your credit report and run it against a complex set of rules to assign a credit score to your credit report. The most well-known (and commercially used) source of credit scores is Fair Isaac Corporation, commonly known as FICO. The second source of credit scores is VantageScore. These two are mostly similar but remain different.
Payment History
Your payment history is the number one factor in determining your credit score. As mentioned earlier, FICO, the most popular credit scoring model in the United States, counts your payment history as 35 percent of your overall score. VantageScore counts it as 32 percent.
When you make payment on lines of credit, such as a credit card, loan, or debt, your payment history is recorded on your credit report.
If you always make your monthly payments on time without fail, this demonstrates to lenders that you are responsible and consistent. In turn, this factor will make a positive impact on your credit score.
On the other hand, it only takes one missed payment to bring your score down significantly. You can have two years of on-time payments, but that one missed payment can negate all your good behavior.
Life happens, and oftentimes when people are in a bind and faced with the difficult decision of either putting groceries on the table or making the credit card payment. But when a payment is missed, their credit score decreases and it can take years to rebuild. If at all possible, make the minimum payment on time each month for all of your recurring expenses.
If you’re unable to make a payment, it is better to contact the lender and set up a late payment than to simply ignore the payment and have it recorded as missed.
The bottom line is that you should make all payments on time. If you have an occurrence when you can’t, don’t ignore the lender. Call and let them know your situation; at the very least, you can make arrangements to pay it late. And in some cases, the lender will offer not to report the payment as late.
Credit Utilization
Credit utilization is a ratio determined by the total amount of revolving credit you have compared to the amount of credit you have used. Ideally, you should not be utilizing more than 30 percent of your revolving credit. Some experts suggest (and we agree) that the credit utilization ratio should be closer to 10% if you want a higher credit score.
If your revolving credit (i.e. your credit card) has a credit limit of $2,000 and your current balance is $500, you have a credit utilization of 25 percent. If you are curious about your credit utilization, you can look at your account online or use the credit card issuers smartphone app to determine your credit limit and outstanding balance.
Your credit utilization is the second most important factor in determining your credit score. This is true with both FICO and VantageScore computing models. FICO counts it as 30 percent of your overall score.
VantageScore also has utilization as the second most important factor, at 20 percent. However, this model goes one step further and uses the balances on your accounts for another 6 percent and your available credit for another 2 percent.
Credit utilization shows lenders how you handle non-cash financial resources. Do you overspend because you have it available or are you conservative with your credit and use it wisely?
This can play a large role in a lender’s decision; even if your credit score is good, if the lender sees a high utilization history, the lender may be hesitant to extend more credit.
Credit Mix
Your credit mix is an overall picture of the different types of credit accounts you have on your credit report. Ideally, it would help if you had a balanced mix of installment credit and revolving credit.
Installment Credit
Installment credit has minimum monthly payments that are fixed – meaning the payment and interest rate will not fluctuate. Installment credit also has a loan maturity date or ending date. You can pay more than the minimum on an installment loan, but you are required to pay at least the minimum.
The four most common installment loans include (1) mortgages, (2) car loans, (3) student loans, and (4) personal loans.
Revolving Credit
Revolving credit is credit that requires more of your attention. Your monthly payments are based on the amount of credit you use plus your interest rate. You typically have a credit limit; however, it can change over time.
Revolving credit does not have an end date. It continues to be a viable source of funds as long as you make your payments.
Example of revolving credit include credit cards, department store credit or cards, and home equity loans.
Why A Credit Mix Is Helpful
A balanced credit mix shows lenders that you know how to handle various types of financial responsibilities. A high percentage of revolving credit may indicate to lenders that you use credit cards when you have cash flow problems, which is not a good sign.
Having no revolving credit may cause them to think that other lenders wouldn’t take a risk on you or that you don’t know how to manage money well enough to handle a credit card.
The two credit scoring models look at your credit mix differently. In the FICO model, your credit mix is 10 percent of your overall score. However, in the VantageScore model, your credit mix is combined with your credit age (see below), which accounts for 20 percent.
Length of Credit History or Credit Age
The length of your credit history is the average age of all your credit accounts. This shows lenders two things. One, how long you have had credit, and two, how often you open new accounts. If you have accounts that you have had for many years and then you open five in one year, your credit age will suffer.
FICO and VantageScore each use this differently in computing your credit score. In the FICO model, your length of credit makes up 15 percent of your overall score. However, as stated earlier, VantageScore combines your credit mix and your credit age to make up 20 percent of your score.
Experts say that it takes seven years to maximize this area of your credit. Before the Fair Credit Reporting Act was passed in 1970, the House and Senate got together to discuss a sensible period of time to wait before removing negative entries off of credit reports.
They settled on seven years and it is still a standard in the industry to this day. Luckily, this factor does not count for the bulk of your overall score.
New Accounts
New accounts on your credit file have a smaller-scale impact on your total credit score. FICO counts these as 10 percent of your overall score, and VantageScore counts it as 11 percent. Opening numerous accounts in a short timeframe appears to be risky behavior for many lenders.
Not only do new accounts fall into their own percentage category, but your new accounts also affect your credit utilization, your credit mix, and your length of credit. It would be best if you kept this in mind when opening new accounts.
Frequently Asked Questions
Now that you’re familiar with the five factors that impact your credit score, you may still have questions. You are not alone! All of the many factors that go into your credit score can be overwhelming at times.
Here are some of the most frequently asked questions regarding what will and will not affect your credit score.
1. Does Checking Your Credit Score Hurt Your Credit Score?
Yes and no. Frustrating answer, right? Checking your credit score can hurt you if it is for a purchase or to obtain new credit – but not all the time.
Hard Pulls
First, a credit inquiry, referred to as a hard pull, is usually instigated when you are buying a house, car, or other big-ticket items that will be financed. A hard pull is also instigated when you apply for a credit card or department store card or loan.
Each hard pull can lower your credit score by five points. You normally recoup those points fairly quickly; however, the inquiry stays on your credit file for two years. Further, if you apply for multiple credit cards and loans, the points can add up quickly.
The good news is that not all hard pulls will pull your score down. The credit scoring agencies have a grace period in their models that recognizes when you are shopping for the best interest rate or loan and only counts it as one pull, not multiple pulls.
For example, imagine you are house shopping and want to get the best interest rate. You use the website to research various lenders and apply for the ones with the best rates. This could be two, five, or even more loan applications.
As long as these are done within the timeframe allowed by each credit reporting agency, the hard pulls will only count one time, not one per pull. Both FICO and VantageScore have a 14-day window to shop around.
FICO goes one step further and does not compute a hard pull for 30 days after it is made. This can be very helpful if the lender approves the loan, but you change your mind and go with another institution. The second lender won’t see a lesser score than the first if it is within 30 days.
Soft Pulls
Soft pulls are when lenders or companies want to see your score; they aren’t looking to loan you money or extend credit. Companies you have accounts with already often use these pulls to determine if you are reliable enough to offer more credit or a better interest rate. It’s like a routine report card they use.
Pre-approved credit offers are not considered hard pulls. These companies have already done a soft pull or are sister companies to your current credit card companies and other lenders.
Lastly, you can pull your credit score anytime and not be penalized. The Fair Credit Reporting Act allows you an annual free credit report from each agency. Check out this article for more details on how to get your credit report for free.
If you want more than one, you can buy these from various credit monitoring companies or the credit bureaus whenever you like and not worry about it being a credit pull.
2. How Does a Car Loan Affect Your Credit Score?
Car loans are installment loans and can affect your credit score in many ways. Before buying a new car and committing to a monthly payment that could positively or negatively impact your score, make sure you understand how it works.
First, your payment history will be impacted as you make your payments on time. However, the opposite can also be true. If your payments are larger than you can realistically afford every month, your payment history could be severely impacted when you miss payments.
Your credit mix will be affected as well. You will be adding an installment loan to your file. If you rent or live with someone and don’t have a mortgage or other installment loan, adding one to your credit mix is good for your credit score.
If you are young and haven’t had time to build a credit history, there are many automotive dealers who have first-time buyer programs. These are beneficial in helping establish a credit score.
If you need to go this route, keep in mind that you won’t be getting the best interest rate. However, after you have paid on the vehicle for a year or two, you can either refinance it for a lower rate or trade it in.
3. Does Having a Zero Balance Affect Your Credit Score?
Having a zero balance credit card sounds like the best plan, and in many ways, it is. Being debt-free is everyone’s dream. However, there are other ways that a zero balance credit card can impact your overall credit score, and not all of them are positive.
Paying your credit balance in full every month is always a good idea. You save interest, increase your credit utilization, add to your payment history, and show lenders financial savvy.
On the other hand, if you carry a zero balance due to inactivity for long periods of time, some credit card companies may close your account. Closed accounts have a negative impact on your credit score. Your payment history, length of credit, and credit utilization all suffer when an account is closed.
Further, inactivity does not necessarily imply that you are fiscally responsible; in fact, some lenders say it makes them wary of approval. Why aren’t you using your credit? Do you have a problem that makes you unable to make payments? These are some questions that a zero balance account may initiate.
Credit experts agree that a small utilization is good for your credit score. It shows that you make payments on time and know how to manage your money. Most of these experts say that people with the best credit score, the top 25 percent, have an average credit utilization score of seven percent.
If you want to keep some activity on your credit card, consider using it to pay a small monthly bill, perhaps your cell phone or cable bill. Then, when your bill is due, pay it in full. You get the benefit of credit activity without carrying a large balance.
4. Will Buying a House (or Getting a Mortgage) Improve Your Credit Score?
Buying a house or getting a mortgage can improve your credit score once you start making payments. Initially, you will see a large drop in your credit score. This drop is due to an increase in your debt. This will eventually even out as you make house payments.
Ultimately, having a mortgage improves your score if you are making your payments on time and not missing any payments. Conversely, if you aren’t able to make your payments on time and you miss one here and there, your credit score will suffer dramatically.
Lenders will look not only at your score but your actual report. If they see that you are repeatedly unable to satisfy the most vital financial obligation on time, your home, they may be very hesitant to approve any loan.
Further, if you have a mortgage foreclosure on your credit, your score will be dramatically impacted, and that can stay on your credit report for seven years or even longer.
5. Does Paying Utility Bills on Time Affect Your Credit Score?
Utility bills are not normally part of your credit score unless you fail to pay them. Utility providers don’t regularly report to the credit bureaus. So, all those on-time monthly payments to the electric company and water commission are not in your payment history.
However, if you fail to pay your utility bills, the providers may send that information to the credit bureaus. Further, if they send your past due bills to credit collection agencies, those will be on your credit report and bring your score down.
There is a bit of good news. Experian offers a program called Experian Boost that pulls your utility payments into your payment history. After you sign up, you give Experian permission to scan your bank account history for monthly repetitive payments. These are then factored into your payment history.
These monthly payments can be anything like your water, cable, electricity, and telephone bills, or even subscription services like Netflix and Hulu that you pay regularly. Further, there is nothing negative that can be pulled, so you are only adding to your credit score.
6. Does Freezing Your Credit Affect Your Score?
Identity theft is a major concern. If you are one of the thousands of people who have placed a freeze on their credit, you don’t have to be concerned that the freeze affects your credit.
Placing a freeze on your credit prevents new accounts from being created using your personal data. This does not improve your credit score; however, it is a proactive step that can prevent your score from being hurt by identity thieves.
One important thing to remember when freezing your credit is that the freeze does not stop a would-be thief from accessing accounts you currently own. If your data is compromised and the thief manages to get into your accounts, your credit score and finances can be destroyed.
Conclusion
There are many factors that impact your credit. The best practice for healthy finances is to pay your bills on time and not over-extend your credit. Once you have a good credit score, be diligent in maintaining it.
