Credit Scores and Credit History
Everyone knows that there’s a mix of factors that are used to determine your credit score. Moreover, everyone also understands that your credit score is an important number. Your credit score influences whether or not you’ll be eligible for different types of financial products like loans and credit.
Additionally, your credit score helps influence the terms you receive on the financial products you are eligible for. Therefore, having a good credit score can save consumers tens or even hundreds of thousands of dollars over the course of their lives.
However, one thing that very few people understand is the way that your credit history influences your credit score. Credit history is more than just the record of payments you’ve made or missed. Credit reporting agencies and businesses use your credit history to determine several important aspects about the financial offers you receive. We’ll look at why credit history is so important, and what exactly it is the financial industry means when they talk about credit history.
Why is Credit History so Important?
There are several reasons why a credit history is important when it comes to determining your credit score. However, the biggest reason why credit history has such a huge influence on your score comes down to predictability.
The financial industry works off of predictability. Institutions make educated bets on what/who is or is not a good investment based on the information they have. Therefore, the more credit history you have, the better companies will be able to predict your ability to pay back the loans and lines of credit you take out with them.
A good analogy for this is if you were to lend someone your car. If a friend you’ve known for years and who has demonstrated tremendous reliability asks to borrow your car, then you would probably let them with minimal fuss or worry. If a friend asks to borrower your car but you’ve known them to be a bit irresponsible in the past, you might ask some questions and get some kind of assurance that they’ll return your car by a certain point in time. If a stranger asks to borrow your car, then you’re likely to say no. After all, you don’t know anything about them, so how can you trust your car to them?
Credit history works the same way. You’re more likely to get a loan or line of credit with a less-than-perfect credit history than you are with no credit history at all. This is simply because the lenders have enough information to determine how much of a risk you are, and can set interest rates at a level where the risk is worth it to them.
What Goes Into Your Credit History?
Credit history is more than a record of your payments. Credit reporting agencies use three different metrics to evaluate your credit history: how long your accounts have been open, how long specific types of accounts have been open, and how long it’s been since those accounts have been used.
How Long Accounts Have Been Open
The first and broadest measure of a person’s credit history is how long their accounts have been open. The longer an account has been open, the more information that account provides to lenders and creditors about what kind of borrower you are. Therefore, people with older accounts are more likely to have a higher credit score than people with younger accounts, all other things being equal.
How Long Specific Account Types Have Been Open
Credit reporting agencies are interested in more detail than just how long an account has been open. Otherwise everyone would sign their child up for a credit card they day they are born so that the child can have as long of a credit history as possible.
Companies are interested in how long specific types of accounts have been open. For example, if you’ve been paying college loans for years but never got a credit card, then companies will be leery about extending you favorable terms on a credit card because you don’t have as much experience with that kind of financial tool.
Moreover, credit reporting agencies give different weight to different types of accounts. Someone who is good at paying back credit cards might not be able to meet the higher obligations that a type of debt like a mortgage can bring to their lives.
How Long Since Accounts Were Used
Finally, credit reporting agencies look at how long it’s been since accounts were used. This is an important consideration. Many people get a credit card account and then never use it, thinking that not using credit show that they are reliable. However, credit reporting agencies see things a bit differently. For these companies, not using an account means that they don’t have up-to-date records about your ability to pay back debts you take on. Therefore, most advisors recommend putting some kind of charge on every revolving credit account you have each month and then paying it off. That way you don’t accumulate debt, and your accounts show recent and responsible usage, which boosts your credit score.
Closing and Opening Accounts
The final thing to understand is how credit history should influence the financial decisions you make. Many times consumers will accumulate some debt, like credit card debt, and then work to pay it off. Once they’ve paid off the credit card they want to close the account. People think that closing the account shows that they’re responsible because they aren’t using credit.
However, closing an account can have a negative impact on your credit score. Companies can’t know for sure why you closed an account. Therefore, you don’t get the benefits you think you will when you decide to close a long-standing account.
Additionally, closing an account can impact other areas of your credit score. For example if you have a credit card with a $10,000 limit and zero balance, and a credit card with a $5,000 limit that is maxed out, you’re using 33% of your available credit, which is pretty good. However, if you close the account with the $10,000 limit, you’re now using 100% of your available credit, which will cause your score to plummet.
As you can see, credit history is greater than the sum of its parts. Make sure you understand the different ways credit history can affect your credit score before you make any decisions about how to handle your accounts so that you can get the best terms possible on the financial products people use every day.