When you apply for credit, the lender orders a credit report from one of the three major credit reporting agencies to learn how much risk it’s taking on.
The lender also has the option to buy your credit score, allowing it to quickly assess credit risk, based on your score. The FICO score, created by the Fair Isaac Corp., is the most commonly used credit scoring system available.
So, what is a perfect credit score?
To start with, scores range from 300 to 850. The highest score a borrower can achieve is 850. While this may be considered a perfect credit score, a lower score of 820 is still excellent and does not necessarily mean the borrower has ever missed a payment.
While each lender has its own scoring standards, a score of 700 or above is generally considered good. Below are the components that make up a credit score.
How credit scores are determined
Credit scores continually fluctuate based on several factors. These include:
- Payment history.
- Credit utilization ratio.
- Length of time with established credit.
- New credit requests.
- Credit mix.
Payment history accounts for 35 percent of your FICO credit score. Consistently paying debts on time significantly improves your score.
Credit utilization ratio
Your credit utilization ratio is the difference between the amount of credit you have available and your debt owed.
For example, if you have $20,000 of credit available but only have $5,000 in debt, your credit utilization ratio is 25 percent.
Experts say that a credit utilization ratio of 35 percent or less is optimal. According to FICO scoring criteria, if you’ve used a large percentage of available credit, this indicates you may be overextended and you are more likely to miss payments.
Length of time with established credit
The length of your credit history accounts for 15 percent of your credit score. As you build credit, your credit history improves over time.
Making multiple credit requests
New credit accounts for 10 percent of your credit score. If you open multiple new accounts in a short time period, this can negatively impact your score.
The impact of credit mix
Your credit mix accounts for 10 percent of your credit score. Credit mix refers to the different types of credit you use, such as credit cards, mortgages and installment loans.
While FICO says that credit mix isn’t a key factor in determining your score, its research shows that consumers who have a mix of credit are slightly less likely to miss payments than consumers who only have one type of credit.
Steps to improve your credit score
Request your credit report
Request a copy of your credit report from the major credit reporting agencies — Experian, Equifax, and TransUnion.
According to the Fair Credit Reporting Act, consumers are entitled to one free credit report from each agency per year.
When you view your credit report, look for inaccurate or missing information. Dispute any errors you find with the credit reporting agency and the creditor. Credit reporting agencies are required to investigate the dispute within 30 days.
Make on-time payments easy
Making on-time payments has the biggest impact on your credit score. The best way to avoid overdue payments is to schedule automatic payments.
If you have a history of missed payments, your credit score will not suffer forever. The longer you make on-time payments, the more your FICO score should improve.
Reduce the amount you owe
Reducing your debt improves your credit utilization ratio.
To be sure, establishing a payment plan that pays down your highest interest accounts first while still making payments on your other accounts allows you to pay off your debt while minimizing the interest you pay.
Credit score myths
A poor score will stay with me forever
This is not true. Your credit score offers a snapshot of your risk profile at a specific point in time. It continually changes as new information is added. As such, your credit score will improve gradually as you make on-time payments and lower your debt.
Closing accounts will help my credit score
This is not necessarily true. FICO never recommends closing a credit account for the sole purpose of increasing your credit score. This is because closing the account may change your credit utilization ratio.
However, if you’re concerned that you will charge more than you should by keeping the account open, it’s probably best to close it.