DE-MYSTIFYING THE MYSTERY
Understanding how your credit score works can seem like a mystery.
To many, it's not unlike a Sherlock Holmes tale with a surprise ending - you go to the bank for a loan, Mr. Banker Man asks you a bunch of questions about yourself, like he's putting together a puzzle of clues. Suddenly, he punches some things into a computer, we cross our fingers, and all you can do is wait for that three-digit number to decide your sorry fate.
And then in one fell swoop, it's over. "Ooh! So close. We're sorry, your credit score came in just 2 points too low. You are the weakest link - GOODBYE."
So maybe it's not that dramatic, but you're told that you don't qualify for the best interest rate, leaving you feeling like the last kid picked at recess for schoolyard football - not good enough, despite trying your best.
Sorry to bring up the painful childhood memories. But guess what? Your credit score doesn't have to be something that you just hope is "good enough" whenever you need a loan. It can be something you can intentionally and strategically build.
So let's de-mystify the mystery of credit scores. Let's bust the myths and break it down to a simple science. Let's turn our credit score from a black box into an IKEA manual - but one without a weird Swedish title.
YOU'RE A PART OF THE SYSTEM
Before you can understand your credit score, you need to understand how you fit within the credit world.
Simply put, you're a part of a system. It mostly starts with your bank or credit union; when you open a deposit or credit account with them, your personal information can be automatically sold into a great database of consumer profiles (unless you opt-out) that creditors and financial institutions have access to. That's why you get enough credit card offers in the mail each month to fill a swimming pool. Not just any swimming pool, but a swimming pool of tempting offers from greedy credit card overlords that will drown your cash flow into oblivion.
Whenever you open up a new loan or credit card, certain information about your debt gets reported into these databases under your name. These databases are overseen by organizations called credit bureaus. There are three major credit bureaus: Equifax, TransUnion, and Experian. Their role it is to compile the data they have about you into a profile called your credit report.
Every time you apply for credit, the lender/creditor pulls a credit report from at least one of the three bureaus and then orders a credit score - essentially a grade - that indicates how well you've paid for things on time in the past. In theory, that's how it works.
Note that your credit report and your credit score are two separate things. You can get one without the other, or both together. The credit score is based on the info that's on the credit report. Also, because you have three different credit reports that can contain slightly different combinations of information, your credit score for each one will be different.
THE FICO SCORE
There are actually several different credit scoring models out there, but the one most used - by 90% of lenders, actually - is created by a company called Fair Isaac Corporation, or "FICO". Their FICO score is usually what people are referring to when they just say "credit score".
FICO is somewhat secretive about exactly how they calculate your credit score - it's a lot like Willy Wonka and how he never let anyone into his factory. But they have publicly disclosed the five
chocolate bar recipes weighted factors that compose most of your score, and you don't need a golden ticket to learn what they are.
Understanding these five major components of the FICO score is what allows you to craft a credit score building plan.
- Payment History
- Amounts Owed
- Length of Credit History
- Credit Mix
- New Credit
Take a look at this impressively attractive diagram, created by yours truly:
Let's discuss each weighted factor one by one from biggest to smallest:
Payment History - 35%
This is the largest factor. It basically asks, "Have you made loan payments on time?" Late payments are reported by how many days late they are: 30+, 60+, 90+, or even 120+ days late. The more late payments, the worse your payment history is, and the lower your score.
The number of accounts that have zero late payments is specifically counted.
Amounts Owed - 30%
As you can see, this is a pretty big chunk of the credit score too. "Amounts Owed" looks mostly at your credit utilization ratio (or "usage ratio"), which is the total balance of your debts as a percentage of all your credit limits combined. So if you have a credit card with a $2,000 balance and a $5,000 credit limit, that's a 40% usage ratio. But if you also have a second credit card with a $5,000 limit but $0 balance, then your overall usage ratio is actually 20%. Capeesh?
In order for this scoring factor to help your score, you'll want to keep your per card and aggregate usage ratio below 30%. So forget the ludicrous myth perpetuated by banks and credit card companies that you want to keep a balance that's almost maxed out and make minimum payments as long as you can (yes, I've actually heard a bank employee teach that to someone as the best way to build credit. They were just regurgitating what they were taught and were gullible enough to believe that it was the truth. Not malicious, but unfortunately ignorant).
If you keep your utilization ratio under 10%, it's even one step better. In fact, the lower that ratio is, the ever slightly better of an effect it can have on your score, though once you're under that 10% ratio the effect won't change as much.
For installment loans, the remaining balance is compared with the original loan amount taken out ("high balance"). The further into the loan you are in paying it off, the better it is for your score.
A couple other things that are looked at with this factor are the overall balance you owe on all debts and how many accounts have a balance.
Length of Credit History - 15%
In theory, a person with more experience in borrowing money will be more likely to pay loans back on time. When FICO looks at Length of Credit History, they are looking at the age of your newest credit account, your oldest credit account, and the average age of all your accounts.
This is why opening a new credit account will lower your score - it immediately lowers your average age of credit.
FICO says that people in the highest score segment have an average account age of 11 years. So yes, this one takes a while to build up and you can see why closing an old account can really tip the scales.
New Credit - 10%
This factor is assessed by looking at how old your newest account is, how many accounts you've opened recently (perhaps in the last year), and how many requests for credit you've had in the last two years. By that, they mean the number of times you've had your "credit pulled", as most people say. On your credit report these are called inquiries, and will be listed for two years, though any inquiries over 12 months old won't be affecting your score that much any more.
Borrowers who have recently applied for credit a lot come across as hungry hungry hippos - always trying to borrow money to buy more stuff that won't leave them any more satisfied. It's best to space out the times you're applying for credit. Applying for two or more credit cards in a few month period can drop your score. You shouldn't be applying for credit in roughly the 12-month period preceding a major borrowing decision like applying for a mortgage or car loan.
Credit Mix - 10%
Tied for the smallest factor, it's not the most crucial but it does count. It's best to have both revolving and installment accounts in your name. Revolving accounts are those that are given a max credit limit, and you can charge to the account whenever you want. Then, you make minimum payments based on whatever balance you've accrued. Basically, this means credit cards and lines of credit.
Installment loans are where a set amount of money is borrowed up front and is then paid back in equal "installments", or payments. Mortgages, car loans, student loans, and in-store credit at furniture or electronics stores all all fit into this category.
Having accounts of both types is a plus, as well as having multiple types of each kind. For example, having credit cards, retail accounts, installment loans, and a mortgage loan would show that a borrower has experience in paying back a variety of different loans.
If you rent from a property management company, rental data is now being reported by some landlords and could be an additional type of credit that's helpful if you're preparing to buy a home.
Those five factors add up to 100%, but within the calculations three cross-factors are used as well: recency, frequency, and severity. This goes for good or bad, but mostly these factors are used to gauge your negative items.
Recency means that more recent credit activity, good or bad, will have a bigger effect than things from a long time ago. The most recent 12 months of credit activity have the biggest impact on your score. As negative items get older, they aren't as big of a deal.
Frequency is indicated by how often you have negative items reported. Do late payments happen often, or did it only happen one time? Are a lot of loans falling behind at once?
Severity refers to the fact that the larger amounts of debt we're dealing with, the more impact it will have. This is why if you have a mortgage - a very large loan - and have made payments on time for several years, you very well could have a score over 800, even with imperfections elsewhere on your report. On the other hand, because a mortgage is such a large loan, late payments will put a good dent in your score and a foreclosure would drop the score several hundred points. On credit cards, the utilization ratios and percentages are important, but a credit card with a $10,000 limit will be weighted more than a credit card with a $500 limit because you're dealing with larger dollars. Higher amounts = higher responsibility, so if you do well, it means a higher credit score for you!
All these factors are calculated and considered to give you a score. The FICO credit score ranges from 300 to 850.
A SIMPLE 7-STEP PLAN
So how do we transform an understanding of these five credit score factors into a a simple plan?
Here is my ultra-succinct 7-step explanation to building and maintaining a high credit score (this is to build credit assuming you're not loaded with credit problems; credit repair takes a different strategy). I say "ultra-succinct" because this is normally what I take an hour to flesh out when I help a client make a credit-building plan. But here is the gist of the 7 steps:
- Establish a Bare Minimum of 3 Credit Accounts - most preferably at least two of them revolving accounts (credit cards or a line of credit at your bank) and one of them an installment loan (like a car loan, student loan, mortgage, etc.). This helps you establish a good mix of credit. Establish these over 1-2 years. Lenders like to see at least three open credit accounts, or "tradelines", if you're going to get a mortgage or other major loan.
- Build at Least a 6-month History - if you're starting from absolute scratch with no credit history and no registered credit score, it will take you six months for a score to be generated.
- Keep Utilization Ratios Low - honestly, the best thing to do with each credit card is to just charge one small bill on it every month - like your Netflix bill or one tank of gas. That's it. This keeps you well under your 10% utilization ratio. Then...
- Make Payments on Time - pay your balance off after the monthly billing cycle is over but before the due date. This way, you're never actually spending more than you would without a credit card, and you never pay interest. On installment loans, obviously pay on time. For an installment loan to really put some good payment history on your credit though, you'll want it to be open for at least 12 months so don't pay it off too early. Notice that between this step and Step #3, you're maximizing the two factors that make up 65% of the FICO scoring model.
- Open a New Credit Account about Once per year - from here, you can add a credit card about once per year until you have few accounts under your name. There's no magic number to how many credit accounts you have, the most important thing is how you use them. Don't open any new credit in the 12 months leading up to a major loan like a mortgage or a car loan. By spacing new credit and being careful with the intervals, you can be sure that the "New Credit" factor won't be bringing down your score too much.
- Repeat and Open/Close Accounts Tactfully - keep on making payments on time while keeping utilization ratios low. Open up new credit accounts slowly until you have 6-10 total active at one time. If you need or want to close any credit cards, consider closing the ones that have been open for the shortest amount of time. By keeping your "oldest" accounts open, your average age of credit will stay up - which is the third biggest scoring factor.
Eventually, you'll have a several credit accounts under your name with long, good-looking payment histories. Your credit score will be built on a sturdy foundation and small things won't have as large of an impact.
- Monitor Your Credit, and Dispute When Necessary - I'd highly recommend subscribing to CreditKarma, Credit Sesame, or some other free credit monitoring service so that you're seeing what your credit history looks like. Note that the "credit scores" that are offered in these services are not the same FICO score your lender pulls, so don't take it as the "real thing." However, it will get you in the ballpark of where your score's probably at.
Once per year, go to AnnualCreditReport.com and pull your credit. This is the one official website set up by government law to give you access to your credit report from each of the three major credit bureaus once every 12 months. The other way to do it is pull the report from one bureau every four months.
If you see any mistakes on your report, don't dismay. At any given time, as many as 20% of people have an inaccuracy on their credit report. Information about you is being passed around between lenders, businesses, and credit bureaus so often that data is bound to get messed up every once in a while on your file. You can dispute items with the bureaus to make informational corrections. It's best to stay up to date so that if you are ever going in for a large loan, you won't be surprised by something that's not supposed to be on there.
So there you have it. It takes some time to build your credit right, but it doesn't have to be a guessing game.
Credit scores aren't too hard to understand once you get the low-down. But there are a lot of myths and differing information that do confuse a lot of people.
Just follow the 7 simple steps above, and you'll be on the right track.