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Credit scores can seem mysterious because they’re created using many factors in your credit report. There are hundreds of different credit scoring models used by companies such as mortgage lenders, vehicle lenders, insurers, and merchants. Each scoring model uses a complicated algorithm to evaluate your credit history. They all use slightly different factors and scoring ranges--some even use letters instead of numbers.
Additionally, there are 3 nationwide credit bureaus (Experian, Equifax, and TransUnion) that may not have the same information about you since creditors may only report data to one or two of them. So your credit score depends on which credit report is used in conjunction with which scoring model.
When it comes to applying for a loan, your credit score matters – a lot. At some point, you’ll likely need to take out a loan for whatever reason, whether it’s to purchase a home, buy a car, or even just to take out a personal loan to cover any one of life’s big expenses. It’s your credit score that determines your chances of getting approved for a loan. Lenders want to hedge against any risk associated with lending money out to borrowers, and a low credit score can be a deterrent against loan approval.
Essentially, a low credit score tells lenders that you’ve had a sketchy financial history that may have involved defaulting on loan payments. A credit score basically tells lenders how reliable or unreliable you are at paying back your loans. Your credit score also dictates the type of terms you’re likely to get if you do get approved for a loan. The higher the credit score, the better the terms will be, including a lower interest rate. Low credit scores typically come with higher interest rates, making loans more expensive. You may even find that your credit score influences your ability to own a house, get a decent cell phone and even obtain a good insurance rate.
Unfortunately, a solid income and employment history aren’t necessarily always enough to keep your credit score up. Credit scores can drop for a number of factors, including the following.
You Were Late on a Payment
One of the fastest ways to put a drop on your credit score is to miss making a payment by the due date. Even being just one day late on a payment will have an impact on your credit score.
Your payment history is a key factor in determining your credit score. In fact, your history of bill payments makes up 35% of your credit score, so those late payments have a major effect on this number. If your payment is over 30 days late, it will be reported to the credit bureau. Each late payment you make continues to drop away your credit score. While the amount by which your credit score drops following a late payment depends on the other information, missing payments has a huge impact on your score and can make it difficult for you to get approved for a loan.
You Reached Your Credit Card Limit
Just because your credit card company has authorized you to use up to a certain amount on your card doesn’t mean you should spend anywhere close to that number. Spending too much on your credit card increases your “utilization ratio,” which is a measure of how much of your credit you’re using relative to your total available credit.
For instance, if your credit limit on your card is 5,000 and you’ve spent close to that amount, your utilization ratio will be considered high and would affect your credit score. If you make a large purchase on your credit card one day, it’s very possible that your credit score will drop even if you pay off the full balance on time.
You Applied For New Credit
Every application for new credit is added to your credit report as an inquiry. When you apply for new credit, the company that you’re applying with will request information on your credit report to check your credit and make sure you’re qualified for approval. These are referred to as “hard inquiries,” whereby lenders review your credit after you’ve applied with them. That includes credit checks when you apply for a credit card, auto loan, mortgage, and so forth. Applying for new credit can negatively impact your credit score, as inquiries comprise 10% of this figure.
That said, inquiries only affect your credit score for one year, which means your score should recover entirely after a year. Only one inquiry shouldn’t have as much of an impact as multiple inquiries would.
You Have Too Many Short-Lived Credit Accounts
Your credit score can suffer if you take out too many accounts within a short time frame. It doesn’t look too good to the credit bureaus if you open up a bunch of accounts without having taken the time to establish them before using them. As far as credit accounts are concerned, a longer history of responsible payment will fare better on your credit score than a short history that doesn’t show much payment activity at all.
You Closed Out an Old Credit Card
You might think that closing out an account would be beneficial for your credit score, considering the fact that taking out too many accounts can negatively affect your score. But closing a credit card can actually harm your score if there is still an outstanding balance remaining on the card. The higher that outstanding balance, the worse for your score. Having said that, the effect of closing a credit card with a balance shouldn’t be that bad if you’ve already managed to establish good credit.
One of Your Unpaid Accounts Was Sent to a Collection Agency
If you have any accounts that are not up-to-date on their payments, eventually they can be sent to collections. Creditors who have not been paid for a while can seek the help of a collection agency that will track you down and collect on bad debts on their behalf. If an unpaid account is sent to collections, it will be included on your credit report and will cause your score to drop.
The Bottom Line
Your credit score plays a huge role in your overall financial health and can significantly impact your borrowing power. It’s important to understand what influences credit scores to help you make all the right moves and avoid the wrong ones to protect your credit score and keep it up where it should be.
If you suddenly notice your credit score drop one month, look back at your past payment behavior and rectify any issues as necessary. Otherwise, pull your report to see if there are any mistakes that may be mistakenly dragging down your score.
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