Your credit score pays a critical role in your finances and affects everything from your ability to qualify for a mortgage to securing a job. Unfortunately, many people still have no idea how credit works and it's hurting them.
If you want to get approved for a mortgage, qualify for an auto loan or save for some other future purchase, you need to get educated now. Understanding your credit today can help you make smarter financial decisions tomorrow and build good financial habits that you can pass on to your children.
So what exactly goes into a credit score and what do lenders actually want to see to approve you for a loan? Here is an explanation of the components that make up your credit.
What Is a Credit Score?
Many people think that a credit score is just one number. However, there are actually many credit scoring models that exists. For the purposes of getting a loan or a mortgage, your FICO credit score is very important.
According to myFICO.com, the consumer website for the FICO score developer, "90 percent of all financial institutions in the U.S. use FICO scores in their decision-making process."
FICO is an acronym for Fair Isaac Corporation, which is the company that developed the scoring system used by the three major credit reporting bureaus: TransUnion, Equifax and Experian. Although each bureau uses the FICO algorithm, there are variations between the score calculated by each of these bureaus. However, all three use these five factors to determine a FICO score:
Your payment history accounts for 35 percent of your FICO score. That is because it helps lenders to determine future long-term payment behavior. The calculation of your payment history includes both revolving credit, such as credit cards, and installment loans.
Although installment loans, such as student loans, are considered to be slightly more important than revolving credit, you should make sure to make all of your payments on-time for the best results. This is how you can improve your score or maintain your current score if it is already good.
Credit utilization is a ratio that shows the percentage of the available credit you've used. You can calculate your credit utilization ratio by adding up your total outstanding balances owed dividing it by the total credit limit across all of your open accounts. Then express this figure as a percentage.
Your credit utilization accounts for 30 percent of your credit score. If you have a high credit utilization ratio, that means that you have large outstanding balances relative to your total available credit limit, which paints you as a risky borrower to lenders.
As a result, you should keep your credit utilization ratio low. Data shows that your credit utilization ratio should ideally be under 20 percent and not higher than 30 percent.
Length of Credit History
The length of credit history refers to the amount of time that all of your credit accounts have been open. It also includes the timeframe since the most recent transaction on an account. Length of credit history accounts for 15 percent of your FICO score. As a result, people who are new to credit will have a more difficult time achieving a high credit score than people who have had longer credit histories.
New credit, which are accounts that you’ve recently opened, accounts for 10 percent of your FICO score. If you are trying to maintain a high credit score, it is a good idea to avoid opening several new credit accounts in a short period of time. This could be a sign to lenders that there is more risk involved in lending you money, especially if you have a short credit history.
Your credit mix refers to the combination of different credit and loan accounts that you currently have or have had in the past, including mortgage loans, installment loans, credit cards, and retail accounts. While it is only a tiny contributing factor to your overall score, it could play a larger role in determining your FICO score if there isn't much other information from which to determine a score.
What’s a Good FICO Score?
FICO scores range from 300 to 850, where a higher number indicates lower risk. Generally, a score of 720 or higher is considered to be an excellent credit score. With a near perfect credit score or credit score of 800, you won't have any trouble getting low interest loans and credit cards with a wide range of perks.
How Do Changes in Your Financial Situation Impact Your FICO Score?
If an unavoidable circumstance occurs in your life that affects you financially, such as the loss of a job or an illness, you may find yourself relying on credit more than you otherwise would. Your FICO score could be impacted if your response to dealing with the situation is taking out additional credit accounts, thus increasing your credit utilization.
In addition, if you end up being unable to make full payments or pay late on your accounts each month, your FICO scores will decline, making it more difficult for you to obtain loans at favorable rates.
On the other hand, a positive change in your financial situation, such as you getting a new job, could be a boon for your FICO scores, allowing you to become less reliant on credit. Using any financial windfalls to pay down credit and loan debt will only help you to improve your credit.
Debt-to-income (DTI) Ratio
A debt-to-income ratio, as known as back-end ratio, compares the amount of debt you have to your gross income. Potential lenders use your DTI ratio as a way to figure out if you can afford to make loan payments each money in order to repay money that you've borrowed. To determine your DTI ratio, simply take the amount total amount of debt that you owe and divide it by your income, expressing it as a percentage. Unlike your credit ratio, your DTI ratio does not impact your credit score.
Why Is the 43 Percent Debt-to-income Ratio Important?
In general, 43 percent is the highest DTI ratio you can have and still obtain a qualified mortgage. While 43 percent is not considered good, it’s not so high that lenders won't allow you to obtain a qualified mortgage. However, Experian recommends keeping your total DTI below 43 percent.
What Is a Good DTI Ratio?
As far as a good DTI ratio, 36 percent or lower is considered to be best. If you can reduce your expenses so that you can lower your DTI ratio so that it is 18 percent or less, that would be considered an excellent DTI ratio.
How Do I Improve My DTI Ratio?
If you want to improve your DTI there are several things that you can do:
- Refinance your debt so that you can pay it off faster. You can do this by opening a balance transfer credit card if you have credit debt. Consider refinancing your student loans. However, make sure to set up shorter debt repayment terms rather than longer ones if you plan to only pay the minimum amount due each month.
- Create a strategy to pay off your debt. You plan should explain how to lower your debt significantly so that it becomes more manageable and eliminate it altogether by a specific date.
- Increase your income. Ask for more hours at work, find a new job or take on a side gig.
Are Student Loans Included in the DTI Ratio?
Yes, just like any other type of debt, your student loans are part of your DTI ratio. That is why you need to deal with out of control student loan debt before it derails all of your other goals, such as buying a home or taking out an auto loan.
Financial freedom is for everyone if you know how to manage your credit. With 2018 just around the corner, now is the time to get your finances in order so that you can start enjoying the life that you truly deserve. Contact us today for help!