Five factors that greatly affect your credit score

Five factors that greatly affect your credit score
Five factors that greatly affect your credit score

Summary

Understanding the factors that affect your credit score is crucial to maintaining a healthy financial standing.

Credit score is a number that reflects the creditworthiness of individuals 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 crucial to maintaining a healthy financial standing. Here are five crucial factors that impact your credit score and what you can do to improve it.

Payment history: This is the most important factor in deciding your credit score. The weightage of your payment history can range between 30% and 35% in your total credit score. This factor checks for two things—first, whether credit bills and instalments of loan have been paid on time or not and second, the number of card payments made till now. The credibility of a person keeps increasing as the number of timely payments increases over a period of time. The reward for paying on time might not be visible directly but the punishment for missing even a single payment is simply too harsh. One should never default on payment as this will significantly reduce the credit score (by around 70-200 points) depending on the payment history. If that happens, a recovery of your credit score to the previous level will, on an average, take 4-6 months.

Credit utilization ratio: In simple terms, credit utilization ratio measures expenses made on a credit card as a percentage of your total credit limit. The weightage of credit utilization ratio can vary between 20% and 30% in deciding your total credit score. Credit limit is the maximum amount of credit that a bank is willing to extend based on the borrower’s income level, total credit exposure, employment details and several other factors but this should not be confused with monthly spending. For instance, if the credit limit on a card is 5 lakh, it doesn’t mean that the lender will be happy to see the cardholder spending that entire amount every month. In such a case, the cardholder will be labelled as ‘credit hungry’ and that will adversely impact credit score. As a rule of thumb, one should always try to keep such spending below 30% of the credit limit. A lower credit utilization ratio (1-10%) will always have a positive impact on your credit score.

Depth of credit: This factor measures your association with credit cards i.e., the length of time that 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 factor is the sole reason why it is recommended that people should not close their oldest credit card account. When an individual’s credit card is closed or cancelled, it affects credit history and, in turn, leads to a reduction in credit score for a short-term period.

Credit mix: Credit cards and personal loans are unsecured loans as these don’t require any collateral, while a home loan is a secured loan wherein the property itself is kept as collateral. Unsecured loans, by nature, are more risker 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 might become stagnant after a point of time.

Number of hard enquiries: Hard enquiry is one that is done by the bank to access your credit profile before approving your credit card or loan application. A soft enquiry is one where individuals check their own credit score and this is never mentioned in the credit report. If you keep applying for credit cards and loans very frequently and thus have too many hard enquiries in your profile within months, banks will again consider you ‘credit hungry’. Further, the rejection of application for a credit card after a hard enquiry will have more negative impact leading to a short-term reduction in your credit score. The number of hard enquiries has almost 10% weightage in deciding your credit score so you should ensure that you are not applying for too many cards or loans too quickly.

Kashif Ansari is as assistant professor at Jindal School of banking and finance, O P Jindal Global University .

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