A credit score is a number that reflects a person’s creditworthiness and how well they are managing their debt. It is also used by banks and other financial institutions to assess the risk of lending money to borrowers. Understanding the factors that affect your credit score is important for maintaining a healthy financial position. Here are five important factors that affect your credit score and what you can do to improve it.
Payment History: This is the most important factor in deciding your credit score. Your payment history can weigh between 30% and 35% of your overall credit score. This factor examines two things – first, whether the credit bills and loan installments have been paid on time or not and second, the number of card payments made so far. The credibility of the individual continues to grow as the number of on-time payments increases over a period of time. The rewards for making payments on time may not be directly visible, but the penalties for missing even a single payment are severe. One should not default on the payment as it will drastically reduce the credit score (around 70-200 points) depending on the payment history. If this happens, it will take an average of 4-6 months for your credit score to return to its previous level.
Credit Utilization Ratio: In simple terms, credit utilization ratio measures the expenses incurred on credit cards as a percentage of your total credit limit. The weighting of credit utilization ratio in deciding your overall credit score can vary between 20% to 30%. Credit limit is the maximum amount of credit that a bank is willing to extend based on a borrower’s income level, total credit exposure, employment details and many other factors but it should not be confused with monthly expenses. For example, if the credit limit on the card is 5 lakh, does not mean that the lender will be happy to see the cardholder spend the entire amount every month. In such a situation, the cardholder would be termed as ‘credit starved’ and this would adversely affect the credit score. As a general rule, one should always try to keep such expenses below 30% of the credit limit. A low credit utilization ratio (1-10%) will always have a positive impact on your credit score.
Credit Depth: This factor measures your association with the credit card, ie, how long you have been using these cards. It checks the average age of all your cards and loans. The longer your credit history, the higher the credit score. This is the only reason why people are advised not to close their oldest credit card account. When a person’s credit card is closed or cancelled, it affects the credit history and, in turn, leads to a decrease in the credit score for a short-term period.
Credit Mix: Credit cards and personal loans are unsecured loans as they do not require any collateral, whereas home loan is a secured loan in which the property is kept as collateral. Unsecured loans are, naturally, more risky for banks. Thus, lenders would love to see a mix of unsecured and secured loans as ideal for your credit score. If people have only unsecured loans in their profile, their credit score may stabilize after a point of time.
Number of tough inquiries: Hard inquiry is what is done by the bank to access your credit profile before approving your credit card or loan application. A soft inquiry is one where individuals check their credit score and it is never mentioned in the credit report. If you repeatedly apply for credit cards and loans and thus have too many hard inquiries in your profile within months, banks will again consider you ‘credit hungry’. Moreover, a rejection of a credit card application after hard inquiry will have a more negative impact leading to a short-term decrease in your credit score. The number of hard inquiries weighs about 10% in deciding your credit score, so you should make sure that you are not applying for too many cards or loans too quickly.
Kashif Ansari is Assistant Professor at Jindal School of Banking & Finance, OP Jindal Global University.
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