Studies show that the average person does not understand what a credit score is made up of. So how in the world can someone legitimately increase their score without actually understanding how the score is determined? The purpose of this article is to help you understand the different components of a credit score. Time and time again, people want to acquire something that they truly want, such as buying a new car. Unfortunately, they either get denied for the car loan or end up with a ridiculously high interest rate because of not mastering the art of credit. Before applying for a loan/new credit, you have to understand: what your credit score is and what makes up the score in order for you to boost it.
Before going further into this article, a person can have multiple credit scores depending on the credit reporting agency. The three major credit reporting agencies are Equifax, Experian, and TransUnion. Although you can have multiple credit scores, generally, they should all be around the same number. So this article is meant to provide general guidance regarding what your average credit reporting agency would use in order to determine your credit score.
There are six components that make up your credit score: credit card utilization, payment history, derogatory marks, age of credit history, credit inquiries, and total accounts.
Credit Card Utilization – High Impact Factor
Your credit card utilization is best summed up as how much of your credit limit you’re using. A lot of people get confused by this, however. So to keep things simple, there’s an easy formula to figure out your credit card utilization: take your credit card balance and divide it by your credit limit. This takes into account all of your credit cards. So for example, if you have a Chase credit card, you would take your balance that’s shown on your statement and divide it by your credit limit. Simple enough right? Unfortunately, not all balances reported are created equal. Some companies don’t actually report the balance that’s shown on your statement each month to the credit reporting agency. Some report the balance a day or two after, which creates a confusion. For example, your balance might show $1,000 on your statement, but let’s say you make $1,000 payment the next day. The balance reported to the credit reporting agency will most likely be $0 due to the timing issue.
So how do you manage all of this confusion? Best practice is to never have a balance on the credit card by your statement date (not to be confused with your minimum balance due date which is normally before the statement date). This will help you avoid interest charges and will keep your utilization rate at 0%. Some people would argue that a 0% utilization rate is not the best way to go about it, but paying 25% interest is not worth it either. The lower your utilization rate, the higher your credit score. It is recommended by many professionals to keep it below 30%, but as stated before, 0% might be where you want to aim. A great example of the credit card utilization is let’s say you do have a Chase credit card. Your credit limit is $2,000, interest rate is 25%, and your statement date is on the 26th of each month. This is your only credit card. On the 26th of this month, you have a balance of $580, which is ironically 29% of the limit. Just enough to keep you within 30% utilization. You don’t use your card for the next few days and so your utilization rate remains at 29%. Keep in mind, however, that interest is calculated based on the balance each month so that $580 balance will increase over time, unless it’s paid off. Had you kept your balance at $0, there is no interest charge. If you have a 0% APR/interest-free card for a certain period of time (i.e. 15 months), then you should leave a very small balance on that card (i.e. $20) during the 0% APR period. This will help you build a stronger payment history, while ensuring that your utilization rate stays low. Just keep in mind that you should knock off the entire balance each month once the 0% APR period has expired to avoid any interest charges. Remember that the lower your utilization rate is, the higher your credit score will be. The higher your credit limit, the lower your utilization rate will be. Also, if you have multiple credit cards, the same exact formula applies for each one. Just sum them all up to get your credit card utilization rate.
Payment History – High Impact Factor
This is simply how many on time payments you make. However, not every agency has access to all of your payment accounts. They normally focus on your loan/credit card accounts. The more on time payments you have, the higher your score. You absolutely should never miss a payment. Just one missed payment can hurt your credit score. So 100% payment history is exactly where you want to be. A great way to manage payments is by setting up automatic payments. However, be sure to monitor the automatic payments to make sure they go through successfully as technical glitches can happen. If you notice any issues with a payment, follow up ASAP. You simply can’t afford to let that mistake go.
Derogatory Marks – High Impact Factor
This has to deal with collection accounts, bankruptcies, outstanding tax bills, foreclosures, etc. You absolutely want to avoid any of these at all cost. If you’re making your payments on time and don’t have problems with the IRS, you will never have a problem in this area. Let’s not even talk about the consequences beyond the fact that even just one of these will damage your credit score and stays on your record for about seven years. The more of these you have, the lower your credit score.
Age of Credit History – Medium Impact Factor
Generally, the more loans you have, the older your credit history and the higher your credit score. Best practice is to keep your accounts open for as long as possible to build a good credit history. Best practice is to also never close an account until it hits maturity (i.e. when the loan is due). However, you have to use sound judgement. If you apply for a loan that has a 15% interest rate, it might be in your best interest to pay it off as soon as possible. Conversely, if you have an interest-free loan, it might be in your best interest to keep it until it hits maturity or when the interest-free period expires, whichever comes first. Paying off an interest-free loan early is one of the worst financial decisions you can possibly make in life. You would simply be throwing away money due to the time value of money. Let’s say you want to invest in a dividend-paying stock that yields a 7% return each year. You would be doing yourself a huge favor by making this investment instead of using the money to pay off an interest-free loan. Best practice is to pay off loans that carry the highest interest rates first, such as outstanding credit card debt.
So keep the accounts that carry low to no interest rates open and try to pay down the accounts/eliminate accounts that carry higher interest rates. Anything at or below a 6% interest rate is a fairly decent rate and you may afford to keep. Anything above 6% should be eliminated or paid down. Accounts such as student loans are an exception, however, since they carry a tax benefit. So if your student loan is at an 8% rate, the student loan interest tax deduction can offset this and justify why you should keep it. In my opinion, the loans you should keep from best to worst are: interest-free loans, student loans, a mortgage, a car loan, a personal loan, and credit card debt. These are in order by typical interest rates from lowest to highest. So the longer you hold your accounts open, the higher your credit score will be, but be sure to use sound judgement when determining which accounts to keep open and which accounts should get kicked to the curb.
Credit Inquiries – Low Impact Factor
Whenever you apply for new credit, generally, a hard credit inquiry is generated. This can have a negative effect on your credit score, unfortunately. The more hard inquiries you have, the lower your credit score. Luckily, hard inquiries get eliminated from your credit score after two years. Best practice is to apply for a limited amount of credit at a time. However, don’t allow it to be something that holds you back from what you think is a great decision. In other words, if you want to apply for a new mortgage, but are afraid that the hard inquiry will reduce the chances of you getting a new car, go for it. A home is certainly not a bad investment (usually). Keep in mind that this has a low impact on your credit score, but you still want to keep the amount of hard credit inquiries low. Normally, things such as a mortgage, car loan, personal loan, etc. will generate a hard inquiry. A soft inquiry, on the other hand, will not scratch your credit score and these are things such as a pre-approved credit card or a credit limit increase granted by the sole discretion of your credit card company (i.e. an automatic credit limit increase every six months).
Total Accounts – Low Impact Factor
Extremely similar concept to the description above in the "age of credit history" section. However, unlike that section, this takes into account both your open and closed accounts. The age of credit history only accounts for your open accounts. The more open accounts you have and the longer you’ve kept them open, the more credit history you have and the higher your credit score. With total accounts, it doesn’t really matter if they’re open or closed. So the more total accounts you have, the higher your credit score. Simple enough.
What is a “Good Credit Score?”
Credit scores range from 300 to 850. A good credit score according to multiple sources is a 720. Keep in mind that not all agencies are created equal. Some say a 700 is good and some say a 750 is good. So if you stay at or above a 700, it is safe to say that you have a pretty good credit score. The perfect score is an 850, which is extremely difficult to have and something you probably don’t want to have. You would have very high standards to uphold if you had a perfect credit score. Generally, you want to have a good credit score no matter what. It can help you apply for new loans and it looks good to have a good credit score. The higher your credit score, the better chances you have of getting approved for a loan and the lower your interest rate will be (generally).
To obtain your credit score, sites such as Credit Karma offer free credit reports. Your credit card company might also give you a free credit score check/report each month, which can be found on your monthly statements. When you apply for a new loan and an inquiry is generated on your credit report, it is required for the lender/whoever caused the inquiry to make your credit report available to you. Lastly, you can pay a fee to obtain a credit report. FICO is probably your best bet to obtain a very accurate credit score.
If you have any questions regarding credit scores or any other topics, please feel free to reach out to me.