A credit score is a 3-digit number, typically between 300 and 850, that depicts your “creditworthiness.” This represents the likelihood of you paying your bills on time, and hence, has a direct influence on whether you are eligible for credit.
Generally speaking, the higher your credit score, the more favorable the credit terms you receive. This is because companies have a reduced risk while dealing with people with higher credit scores and can pass on the benefit back to the customer.
However, if you have a poor credit score, companies have good reason to believe you may not pay back the loan, and therefore, they need to charge you a higher interest rate to balance their risk vs. reward ratio.
Wondering what is a credit score and how is it calculated?
How are credit scores generated?
Credit scores are generated using the information in your credit reports, including your payment history, debt, and the length of your credit history. FICO, a popular model used by most lenders, uses five criteria to compute credit scores. Each measure carries a certain weight:
- Payment history – 35% weightage
- Credit utilization ratio – 30% weightage
- Length of credit history – 15% weightage
- Credit mix – 10% weightage
- New credit – 10% weightage
Another major credit score model, VantageScore, uses an average of five measures while computing credit score:
- Total credit usage, balance, and available credit
- Credit mix and experience
- Payment history
- Age of credit history
- New accounts
When one or more of these areas are negatively affected, it will also negatively impact your credit score. The quantity and duration of your credit score will drop depending on the severity of the issue and how it reflects against your recent and long-term credit history.
Banks and credit card companies then use these credit scores to determine whether to offer you credit and how much interest to charge you on it.
Your credit score can change from month to month, week to week, or even day to day based on when credit bureaus receive new information from lenders. While small fluctuations are perfectly fine, it’s probably worth investigating further if you notice a drop of 20 points or more.
Reasons your credit score changes
So what can be some of the reasons behind a large credit score drop? While there are some obvious causes, such as missing your payment or taking a large loan to cover a previous loan, there are also many reasons that are less apparent and probably not even your fault.
1. Late or missed payment
Not paying your bills on time has a large impact on your credit score. A person with a high credit score will likely experience a bigger drop in their score for a missed payment than a person with a moderate to low credit score would.
This is because defaulting even once is considered more significant for a person who pays his bills on time than for a person whose credit score already reflects a history of missed payments. But regardless of your credit history, the longer you delay your payments, the greater your score will drop.
2. Derogatory mark on your credit reports
Negative information on your credit reports can drastically affect your credit score. For instance, bankruptcy notifications on your report can adversely affect your credit score for years.
Other derogatory remarks that can drop your credit score include foreclosures, defaulting on your mortgage, and collection accounts after failing to repay a debt.
Although derogatory remarks are likely to stay on your credit report for a long time, their impact tends to reduce over time.
3. Change in credit utilization ratio
Maxing out your credit card may seem tempting but can cause a quick drop in your credit score. Running up your balances can increase your credit utilization ratio, making it appear to lenders like you are stretching your finances and not in a good position to take on new debt.
The credit utilization ratio is calculated by summing the balances of all your credit cards at any given time and dividing that by your total revolving credit limit. Ideally, you should aim to keep your credit utilization ratio below 30%, and for the best scores, below 10%.
4. Reduced credit limit
If a lender or credit card company reduces your credit limit, it increases your credit utilization ratio and, in turn, lowers your credit score. If this is the case, you could ask the lender to raise your credit limit to lower your utilization ratio.
Alternatively, you could pay off your current balance to decrease your utilization ratio.
5. You closed a credit card
Many experts recommend keeping your credit account open, even if you don’t use the credit card anymore. This is because closing your account can reduce the overall length of your credit history, and with a smaller total credit limit, your credit utilization ratio would rise.
The older an account, the more it could affect the average length of your credit history. So, before you close your oldest credit accounts, consider whether it’s absolutely necessary.
6. You paid off a loan
While paying off installment debt like student loans or mortgage improves your overall financial position, it may also lower your credit score.
However, this impact is likely to be much smaller, so when you’re ready to pay off a major loan, don’t worry! The extra interest charges are probably not worth keeping your credit score a few points higher.
7. You’ve recently opened or applied for multiple lines of credit
The lender or creditor usually performs a hard credit check to review your creditworthiness when applying for credit. According to FICO, hard credit checks can temporarily drop your credit score by up to five points for a year.
So, if you apply for multiple credit products frequently, it can drastically lower your credit score.
8. Mistake on your credit reports
Sometimes creditors make mistakes while reporting your credit information. That’s why it is important to check your credit reports regularly and look out for errors; make sure your accounts and personal information are accurate. If you discover a mistake on your credit reports, you should dispute it with the credit bureaus and the reporting lender by mail or phone.
Also, look out for accounts you never opened, as it could mean that you are a victim of identity theft.
9. You were the victim of identity theft
A less apparent but extremely frightening reason for a drop in credit scores is identity theft. According to Panda Security, nearly 60 million Americans have been victims of identity theft in one form or another.
Perpetrators use your identity to apply for and open credit accounts in your name. They can then run up your balances, which negatively affects your credit utilization ratio. If you believe you’re a victim of identity theft, you must immediately file a report and freeze your credit with all credit bureaus.
Next steps
Your credit score is an important number that can either cost or save you a lot of money. It is up to you, as a borrower, to ensure your credit remains strong so you have access to more and better opportunities to borrow, should the need arise.
We know that poor credit scores can be nerve-wracking. But don’t worry – we are here to assist you. So here are a few tips to help you improve your credit score.
- Ensure you pay your bills on time – this is by far the most important factor. You should aim to pay your bills on time for at least six months for a noticeable improvement in your credit score.
- Call the bank or credit card company to inquire about a credit increase if you have credit card accounts. If granted an increase in your credit limit, don’t spend the entire amount. We know it can be tempting to buy that new Gucci wallet, but hold up! Not utilizing your entire credit increase allows you to maintain a lower credit utilization rate, thus improving your credit score.
- If you don’t have time to improve your credit score, you can hire credit repair companies to negotiate with lenders and credit bureaus on your behalf.
- However, if you have considered all options and decide it is in your best interest to close the credit card, we recommend canceling recurring payments, paying off your credit card balance, and checking your credit score reports for the next few months.
- Regularly checking your credit report and credit score is a good habit of mitigating the effect of any potential credit score drops. It is also worth noting that monitoring your credit report does not impact your credit scores; instead, it will help you better understand your current credit position.
So if you are someone who cares about your credit score and want to be rewarded for credit score increases, we invite you to apply for early access to Vital. We are the credit card that pays you to share and spend responsibly.
Sources
“What Is a Credit Score…?https://www.nerdwallet.com/article/finance/credit-score-ranges-and-how-to-improve” NerdWallet
“FICO Score,” FICO
VantageScore.com
“7 Things You Didn’t Know Impact Your Credit Score,” Investopedia
“Identity Theft Statistics,” Panda Mediacenter
Vital Card blog posts are intended for informational purposes only and should not be considered financial or any other type of advice.