Credit scores are a major factor in personal finance – especially when it comes to mortgage loans. Most residential mortgage loan programs have minimum credit score requirements for eligibility. Furthermore, higher credit scores almost always lead to better interest rates which can result in easier qualifying and/or substantial monthly payment savings.
The exact breakdown of how credit scores are calculated is closely guarded by the three major credit bureaus (Experian, Transunion, & Equifax). This being said, much of the information that has been made available surrounding credit points to five main categories which even have a breakdown of the percentage weight each carries.
The first, and most significant, factor contributing to your credit score, an estimated 35%, is on-time payment history. For a payment to be considered on time, the minimum payment required must be paid in full before or on the due date. Late or missing payments can stay on your credit report for up to seven years making it critical to avoid this at all costs. Two of the best ways to ensure all payments are made on time are by limiting the number of accounts you regularly utilize and setting up auto payments.
The second most important factor, contributing approximately 30% towards your credit score, is credit utilization. Credit utilization takes the outstanding balance on all of your revolving credit accounts (Credit Cards, HELOCs, or other varying lines of credit) and divides them by the total credit limit available. For example, if you have 3 credit cards all with a $5,000 credit limit and you owe $1,000 on each account your credit utilization would be approximately 20% ($3,000 / $15,000). The lower the utilization ratio the better (30% credit utilization is widely considered to be a good target. However, other data claims as low as 10% to be ideal).
The third most significant factor contributing to your credit score, coming in at an estimated 15%, is the length of your established credit history. Only the passage of time can improve this. In general, as long as you are making all your payments, the sooner you start building credit the better. Some of the best ways to get started building credit include opening a secured credit card, becoming an authorized user on a credit card, or manually reporting payments on things such as rent or utilities.
The last two factors, contributing approximately 10% to your credit score each, are your credit mix and newly established credit inquiries. Credit mix refers to the types of accounts that you currently have open and are making payments on. Some common types of accounts include credit cards, auto loans, student loans, and a mortgage. An individual with multiple different types of accounts is likely to have a higher credit score than the same individual with just one type of account. That being said, because it is only 10% of your score, it is not always the best idea to open different types of accounts in an attempt to boost your score.
Newly established credit inquiries refer to newly opened lines of credit relative to the date of your credit being run. In general, the lower amount of recently opened accounts and credit inquiries you have on your report the better. Additionally, if you are looking to add new credit accounts try to do so over an extended period of time rather than all at once as opening too many new accounts at the same time can be seen as a red flag. On the flip side, if you are shopping for something like an auto loan or a mortgage where you will only open one account once you find the best rate, try to do so close together because multiple inquiries for the same category in rapid succession are not punished as hard.
Overall, your credit score is composed of the following five factors:
- Payment History
- Credit Utilization
- Length of Credit History
- Credit Mix
- New Credit & Inquiries
Being aware and knowledgeable about each category is the first step toward building excellent credit. If you are looking for a home loan and have any questions about credit, please do not hesitate to reach out to one of our mortgage loan consultants at (760) 930-0569.