We all know that credit scores exist and that lenders use them when we apply for a new credit card or loan. These scores may seem like a black box, but they aren't. So if you're thinking, ‘so what is a credit score, anyway?', then look no further. We've got you.
Credit Score Basics
A credit score is number ranging from 300 to 850 that serves as your credit report card.
Ever heard of the word FICO? Credit scores and FICO scores are the same thing. A credit score is supposed to estimate how likely a person is to repay their debt. It takes a lot of different factors into account and determines if you're an attractive borrower or not. If you have all your credit cards maxed out and full of late payments, new lenders will steer clear. A quick glimpse at your credit score will tell them everything they need to know.
The higher the credit score, the more likely a person is to repay the debt. Before we jump into how scores are calculated, do credit scores even matter?
Do Credit Scores Matter?
Yes, but their impact will depend on your specific situation.
In short, the reason your credit score matters is because having solid credit can save you a lot of money. You'll save money because when you apply for a mortgage, auto loan, or any other type of loan, you'll qualify for the lowest interest rates possible.
Why do you get lower interest rates with a higher credit score?
When companies are going to lend you money, the thing they care about most is that you'll repay them. If you have a lower score, they'll think that there's a higher chance that you will NOT repay them. For that reason, they will only lend you money IF it comes with a higher interest rate to compensate them for that higher risk.
This creates a vicious cycle, because the people with low credit scores who might not have a bunch of extra money laying around, end up paying the most money in interest.
This is why your credit score matters. I think the example below highlights it perfectly.
Calculating Credit Scores
When you think about how your credit score is calculated, it may seem like a black box. But thankfully, this black was left unlocked and we know the recipe.
Several factors that are taken into account to calculate a credit score.
Here the factors for your credit score and how they are weighted:
- 35% of your score is based on payment history
- 30% is based on percent of total credit used
- 15% is based on the average age of all accounts
- 10% is based on new credit applications and credit inquiries
- 10% is based on the number and type of credit accounts
How On-Time Payments Effect Your Credit
Do not make late payments.
Do NOT do it. Try as hard as you can to not be late.
Pay the minimum (or more) on each credit account (loan, mortgage, lease, etc.) by the due date each month. If it's a credit card, aim to ALWAYS pay off the balance in full. Credit cards have extremely HIGH interest rates, so if you carry a balance month-to-month you will get absolutely crushed by interest charges.
If you do miss a payment, you will often get charged a late fee as well, so it's a double whammy.
Many people struggle with this. It is easy to forget to pay your account by the due date. Technology has fortunately helped with this as nowadays you can set a digital reminder.
Better yet, simply automate it.
I have had auto-payments set on my credit cards for years (for the full statement balance), and have NEVER missed a payment as a result.
Your Percent of Credit Used (Credit Utilization) Matters
The large credit bureaus use multiple criteria to determine your credit score. One of those that relates directly to credit cards is the percentage of your credit limit used. For example, if you have a total of $2,000 available across all of your credit card accounts and have spent $150, that would be a credit utilization of 7.5%.
Your goal should always be to keep it as close to 0% as possible, especially if you are applying for a new credit account or a loan.
If that sounds hard, remember that having a budget is key. Sometimes it is necessary to make multiple payments during the month. By paying the credit card off regularly you will ensure your balance is always low (or zero).
If you follow our philosophy on credit cards, you should only be using credit cards to spend money you have in your bank account and never spend money that it not accounted for in your budget. Racking up credit card debt can destroy dreams of financial freedom!
The good news is that your utilization is a snapshot in time. That means it doesn't matter if your utilization 6 months ago was 17% and your are about to apply for a mortgage. What matters is your current or recent utilization, so before you apply for credit, make sure you pay down those balances. Below 2% is a really solid credit utilization goal!
An Older Average Account Age Is Better
The total average “age” of your accounts is factored into your credit score. They average the total amount of time that your accounts have been open. This includes private loans, student loans, and credit cards. The “older” your accounts are the higher your score will be.
This matters because it tells lenders that you have been a responsible user of credit for a longer period of time. Easy enough.
Remember, it is possible to have a credit card account open and not use it regularly. This can increase your “credit age”. To prevent the account from being closed you may need to use it to pay a small recurring monthly bill. Do not spend extra though.
Simply leave the card at home to prevent the temptation to use it. If keeping it out of your wallet is not enough, you can destroy the card by cutting it up into pieces.
Do NOT ever carry a balance though. Also, do NOT spend more than what you have budgeted for.
Also, if your oldest account charges an annual fee, there's a good chance you'd be better off closing it in order to avoid the fee. Thankfully, my oldest credit account has no annual fee, so my plan is to keep it open for the rest of my life.
Credit bureaus track every time you apply for a new line of credit (loan, credit card, etc). They do this to measure how you are doing financially. Opening many accounts within a small window of time lowers your credit score.
If you've ever heard of soft or hard inquiries on your report, this is what this refers to. Every time a lender or a 3rd party accesses your credit report, they essentially file an inquiry. This will live on your credit report for a period of time. The good news is that hard inquiries should only impact your score for 12 months.
If you want to boost your score, simply limit the number of inquiries.
A Wider Breadth Of Type And Number Of Credit Accounts Is ‘Better'
Diverse loan accounts are preferred by the credit bureaus. This can include car loans, mortgages, student loans, and credit cards. Those with different types of accounts tend to have higher credit scores. This may seem counterintuitive, but we don’t make the rules.
An analogy is to think of a friend who is a baby-sitter. If they only baby sit babies who are 6 months old, compare them to someone who has experience with kids of all ages. It's easy to say that the person with a wider range of experience is a bit more well rounded as a baby sitter. That's not to say that your friend isn't the world's best baby sitter of 6 month old babies though. In a similar train of thought, if banks see that you are responsible with credit cards, auto loans, a mortgage and a private loan, they'll see that you probably would treat their knew loan with the same amount of responsibility.
With that said, do NOT go and open a personal loan just to boost your credit score. Your credit mix accounts for only 10% of your score, so it really doesn't make a big difference.
If you really want to improve your credit score, simply focus on the basics. Always make on-time payments on all of your accounts, lower your utilization, and keep your oldest accounts open.
Credit Score Killers
Three things will hurt your credit score A LOT:
- Filing for bankruptcy
- Having accounts sent to collections, or
- Foreclosing your home.
If any of these have happened to you, work on all the other things above if you are looking to raise your credit score.
Also, just remember that credit score are not the end-all be-all of life. If your credit score sucks, then work hard to fix it, but don't give up or let it affect your self-esteem. You are more than your credit score.
A Good Credit Score Does Not Mean Financial Success
At the end of the day, credit scores are an artificial score to try to gauge how good of a lending prospect you are. That's it.
It doesn't really say anything about how good you are with money. It's possible to be in debt up to your eyeballs, live paycheck to paycheck, and still have a credit score over 800.
At the same time, you can have a credit score under 600 and be debt free, and have a TON of cash in the bank.
We would much rather have the low credit score and NO debt, would you? Don't obsess over your credit score.
Just stick to your budget and make solid financial decisions. For most people a solid credit score will follow.
Camilo is a personal finance expert who was raised in poverty by a single mother and had to learn everything about personal finance on his own. In addition to running The Finance Twins with his twin brother, he has been featured on Forbes, Business Insider, CNBC, US News, The Simple Dollar and other top publications. Camilo began his career as an investment banking analyst on Wall Street at J.P. Morgan. He has a master of business administration (M.B.A.) degree from Harvard University and a Bachelor of Science in finance from the Wharton School of Business at the University of Pennsylvania. You can contact Camilo here or via Instagram @thefinancetwins.