If you’ve read the article on “Opening Your First Credit Card,” then you know the basics behind credit cards and how they can help you build credit on your own. But what does credit even mean and why should you worry about it?
To start off, credit refers to your personal credit score or FICO score – generally ranging from 300 to 850 – and can be calculated in many ways by different credit agencies like Experian, TransUnion, and Equifax. Though credit scoring methods may differ in the data they use, the chart below outlines the most common components and their corresponding weighting.
The first eye-popping takeaway from this pie chart is that your payment history and current debt make up 65% of your total score! So, you should really focus on staying on top of your bills and what debts you owe. Here are some brief descriptions of each section and best practice in each to make sure that your credit score is improving and stays above 670 (the bottom of the “good” credit score range).
- Payment History: This is pretty self-explanatory and simply refers to how consistently you have paid bills in the past. If you pay all your bills on time then your score will gradually improve with a history of timely payments on your record. But, if you make a late payment your credit score could be slightly dented.
- Amounts Owed: This again is what it sounds like – how much current debt you have and assessing your ability to take on and pay down new debts. Obviously, none of us want to be in debt, but life happens, and you will need to take on student loans for college, finance your house through a mortgage, and maybe take out an auto loan on a new car. These are to be expected just do not overextend yourself into debt by buying too many items on credit (i.e., using money that you don’t have to pay for goods now by borrowing).
- Credit Utilization is also a component of this category and refers to the amount of your credit limit that you use. For example, say you open a new credit card with a credit limit of $1000 and you currently owe $300 on your purchases for the month. Then, your credit utilization is 30%. It is recommended to keep this number at 30% or lower.
- Length of Credit History: The longer you have accounts open, the better. While in college, you likely will only have a credit card account that is relatively new, so your credibility in account length will come as you age. Just make sure to keep the account open unless you have a valid reason for closing it. Mortgage and car payments help boost this category, but likely won’t happen until after college.
- New Credit: Credit agencies don’t like to see lots of applications for new credit such as loans or opening multiple credit card lines because they want you to focus on minimal debt payments and not have to need to service debt by taking on more debt (e.g., opening a new credit card to pay off debt on your existing one).
- Types of Credit in Use: There are 3 types of credit that agencies look at – revolving (think credit cards), installment (auto loans, student loans, mortgages), and open. They check to see if you have a healthy balance of the 3 and if you can realistically pay them all off.
So, why should you care and monitor your credit?
The better your credit score is, the lower your interest rate usually is. When you want to finance a home, you may get a 3% financing rate if you have an excellent credit score compared to 5% with a fair score. This can be applied to almost any kind of debt that you may encounter through personal loans, credit cards, auto, homes, etc.
Oftentimes, you will start in the fair to good range, but can improve into the excellent tier by properly following the criteria above. Building credit is a process and takes time and effort, but you can achieve excellent rates by making payments on time and not overextending your debt levels!
To monitor your credit, make sure to check out a FREE credit report from one of the 3 credit agencies (Equifax, TransUnion, Experian). You can get a free report from each agency every 12 months. This is incredibly important to in the age of identity theft.
This article was written by guest blogger, Carter Hodgson. Carter is a third-year student majoring in Economics and Mathematics. He is from Austin, Texas and is the President of Emory Roundnet (Spikeball). He is also involved in the Honor Council and is a research assistant for one of his finance professors. In his free time, you might see him playing spikeball, soccer, or football, checking his fantasy football team, studying in Cox Lab, and hanging out at Bread Coffeehouse. He has started writing blog posts for Emory Financial Literacy and loves to continuously learn about personal finance topics.