The US Credit System
As soon as you open any line of credit - a mortgage, auto loan, or credit card - you will start building your credit score. Often referred to as your FICO score, your credit score is measured on a scale from 300 to 850, with the higher being better.
Your credit score is used by businesses and banks to estimate how likely you are to pay back a loan on time, be it a mortgage or credit card transaction. A strong credit score is often necessary to make important purchases like a home or a car. Additionally, your credit score will affect the terms of the loan — the stronger the score, the lower the interest rate.
Your credit score will be calculated by three different companies: Experian, Equifax, and Transunion. Because each company uses a slightly different calculation method, you may end up with three slightly different credit scores.
Factors that Determine Your Credit Score
Payment History
Your payment history makes up the largest contributor to your score (35%). Each time you make a payment on time, you get a little boost, while each time you miss a payment, your score goes down. Unfortunately, though, these two aren’t equal: a late payment will hurt your score a lot more than an on-time payment will help it. This is why it’s so important always to make your monthly payments on time!
Debt Burden
The second largest contributor to your score (30%) is called your “debt burden.” This refers to several factors, such as the total amount of debt you owe, the number of loans you have, and your debt-to-limit ratio or credit utilization. Credit cards have balance limits, and the closer you are to that limit, the more it looks like you might be having a hard time managing your personal finances. High credit utilization can make you look like a risky lender and thus lower your score. For example, a $5,000 balance on a credit card with a $30,000 limit might actually help your score - you aren’t using much of your limit, so you appear responsible. That same $5,000 balance on a card with a limit of $5,500, however, would lower your score. Again, this is another reason to always pay your credit card bill in full and on time.
Credit History
The length of your credit history also contributes to your credit score (15%). As your credit score is essentially an assessment of how trustworthy you are to repay a loan, the longer financial institutions have had to monitor your behavior with credit, the more confident they can be that their prediction is accurate. A perfect payment history over one year doesn't mean as much as a near-perfect history stretching back 15 years.
Types of Credit
A smaller contributor to your score is the types of credit you hold (10%). Types of credit include mortgages, auto loans, student loans, and, of course, credit cards. Having several types of loans is seen as a positive in that it indicates the borrower is familiar with and capable of maintaining different types of loans successfully.
Recent Credit Inquiries
Finally, the last contributor to your credit score is the number of recent “hard inquiries” when a lender requests your credit data, like when you apply for a new credit card or auto loan. Many recent inquiries can lower your score, as it makes you look like you are desperately trying to secure additional lines of credit.
Your credit score will follow you for as long as you plan to live in the US, and it’s generally much harder to raise your score than lower it. That’s why it’s important to stay on top of your credit: always make at least your minimum payments on time, don’t get too close to your loan limits, and, if possible, pay off your entire credit card balance each month.