So you’ve read Adulting Part 1. You know the ins and outs of how leasing a car works. You’ve taken that knowledge, negotiated the price down and now you’re at the final stage—financing the car. Eager to walk off the lot that day (or night) with your everyday dream car, you’re probably going to be quick to skim and sign every paper the dealership throws at you. Aside from all the paperwork that establishes the contract between you and the dealership you’ll also be given a copy of your credit check.
This three-digit number basically decides your fate. If the score is too low, the other party may charge a higher interest rate or decline the contract altogether. Even though you may not take out a loan to lease a car, the dealer will still run a credit check to see the likelihood that you’ll be able to make the monthly payments.
If all you know about credit scores is the “Free Credit Report.com” jingle, don’t worry. This article will look to answer some basic questions about credit scores. We all know that a higher score is better, but what exactly is a FICO credit score? Why is it so important when applying for loans and credit cards? And how can you improve your score?
To give some background, the credit score traditionally used by the big three credit agencies—Trans Union, Experian, and Equifax—was developed by the Fair Isaac Corporation, hence the name FICO. The FICO calculation model was created in 1989. Since 1989 the FICO model has grown to be the most popular means of calculating someone’s credit.
Before the introduction of the FICO score, there was some controversy over the way in which credit scores were calculated—incorporating non-financial information such as drinking habits or cleanliness. In 1971 Congress passed the Fair Credit Reporting Act which looked to increase the accuracy of credit reporting. Since then, methods like the FICO method attempt to construct a score based on the only relevant information.
As mentioned before, you score is a three-digit number ranging from 300 to 850. Your credit score is an indication of the likelihood that you’ll repay your debts on time. Higher scores indicate a greater likelihood that you’ll pay back your debts on time. The median score in the U.S. is 725 and a score over 770 usually will get you the lowest rate.
So how is your score calculated? Your FICO score is broken down into five components, each with different weights: accounts owed at 30 percent; payment history at 35 percent; new credit at 10 percent; credit mix at 10 percent and length of credit history at 15 percent.
Most of these are self-explanatory, however, a couple of them are a little bit trickier than they appear. Accounts owed indicates how much money you owe on each of your debts. Even if you pay off your credit card in full every month, there’s still a chance that your credit score will be lowered. You should try to have less than 30 percent of your credit line owed at any time to prevent it from hurting your score. In this case, it may actually be beneficial to have more than one credit card. Therefore, you can distribute the load evenly instead of maxing out one card and hurting your score.
Credit mix indicates the type of credit accounts you have. This section includes credit card accounts, retail accounts, auto loans, and mortgages, as well as loans more generally. What benefits this section is not having each of these accounts, but instead managing them efficiently. For instance, it will actually improve your credit score to have loans and credit scores if they’re repaid on time and your score will be higher than those without any accounts. This is because people without credit accounts are seen as riskier borrowers as there is no statistical data to analyze their finances.
As for the other components, they’re fairly straight-forward. Payment history looks at the history of you paying your previous debts. New credit looks at how many new accounts have been added. Typically, you do not want to open many accounts at once, as it makes it appear as if you’re attempting to borrow more money than you can pay back. Last is the length of credit history. Longer history will indicate that you’ve been a good borrower for longer and help bump up your credit score. The history component looks at both your newest and oldest accounts.
So how can you raise your credit score, especially as a post-grad? First off, if you don’t have a credit card you should open up an account and begin to have a credit history. In addition, if you find that you’re maxing out a card not because you’re short on cash but because you prefer the feel of plastic to paper you may want to open up a second account. As long as you can afford to pay off your debts on those cards month-to-month it might make more sense to open another account. Second, make sure that you’re paying your student loans off every month. Not paying your loans will indicate that you’re less likely to pay back future debts. It’ll also raise your debt to income ratio which will hurt you in the long-run.
It’s important for young people to achieve and maintain a good credit score. A lower credit score will be a financial burden in the future, especially when looking to finance the purchase of a house. A difference in a percent or two in an interest rate can drive up the total amount you’ll need to pay by thousands.
Having debt isn’t a death sentence if it’s managed with diligence, in fact, it’s part of the healthy financial life of every American. So get out there, pay off your bills and rack up some sweet credit rewards.
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