Financial Report Card: Breaking Down your "Credit Score"

30% of Americans have bad credit and I'm here to make sure you find your way to the other 70%.

Essentially, your credit score is a “financial report card”. It’s a numerical value between 300-850 that represents how likely you are to repay your debts in a timely manner. [

First, Why should you even aim for high credit?

If you are interested in purchasing a home, car, or anything that requires a loan you will want to focus on your credit score. Because your credit score represents your likeliness to repay your debts in a timely manner, lenders want to know whether or not they can trust you with a loan. If you have poor credit, you may get hit with higher interest rates. 

Your lender wants to make money off of you borrowing money, so they charge “interest” which is a percentage of the loan that you have to pay extra in exchange for borrowing money. By charging a higher interest rate, the lender is saying that you might be a risky borrower, and they want to get more money out of you in case you can’t pay the loan back. 

The higher the risk, the higher the rate. 

Why do I even want a loan?

Now there are many who will say that they don’t need a loan for big purchases. Instead, they will save up to pay for big purchases in cash. But even if you had cash to pay outright it could make more sense to still get a loan. 

Because loans are paid off in "small chunks" called installments rather than all at once, you will have more money on-hand to use however you want. You can invest, spend on utilities, perhaps purchase more real estate. 

Back to credit. A higher credit score also enables you to qualify for exclusive credit cards that offer benefits such as cashback, rewards, travel miles, and more. Who doesn’t want that?!

The factors that lenders use to track credit scores - like debt and payment history - can affect whether or not you are potentially hired at some jobs. Employers sometimes check a modified version of your credit report as an indicator for financial problems that might indicate risk of theft or fraud. You can see your own credit report - it's a summary of your financial history paying back debts or bills. 

Although they aren’t looking directly at your credit score, we wanted to include this one because the factors that indicate good credit are reflected here. 

So who Calculates OUR Credit Score? 

Just like how national testing agencies like the ACT or SAT have a specific scoring system that colleges use to determine students' academic abilities - Credit Bureaus (also known as Credit reporting agencies) allow lenders to pull your credit score to determine your ability to pay back a loan.

In the US, the three national credit bureaus are Equifax, Experian and TransUnion. 

They track most of our credit histories. Each of these agencies uses the FICO® Score algorithm to produce a version of the FICO® Score based on the data they collect on each consumer. FICO is not the only credit score available, but it is the one you will hear the most. 

So in order to achieve a perfect credit score, we need to understand how the FICO scoring algorithm analyzes the information on our credit report. 

Breaking down the Credit Score

Payment history — 35%

Payment history has the largest influence on your credit score over any other category, worth 35% of your overall score!

The credit scores overall purpose is to predict if you’ll be 90+ days late on any credit account within the next 24 months. If you already have a history of paying bills late, it’s more likely that you will make a late payment on a credit line.

A credit reporting agency — Equifax, TransUnion, or Experian (or all three) — may receive updates about your payment history from your credit cards and lenders, or collection agencies. 

Here’s a unique example. 

Now this is a ~very unique~ example, but let's break it down. After being overdue on your library book, your "late fee" is reported to a "credit reporting agency", in this case, a collections agency. Once the "late fee" is reported to the credit bureau, they are the ones who will change your score. Typically, your score will drop when your credit card company or lender reports late/missed payments.

Amounts owed — 30%

Amounts owed is the second-most influential of the credit score factors. Worth 30% of your FICO Score, the amount of debt you carry (especially credit card debt) is nearly as important as whether you pay your bills on time.

The primary factor FICO considers in this category is known as credit utilization. Your credit utilization ratio describes how much of your available credit or credit limit  you use each month on revolving credit accounts.

For example, if you have a card with a $1,000 credit limit and you spend $200 you would be utilizing 20% of your credit.

If you want a chance to earn a great credit score, aim to maintain the lowest utilization rate you can while still proving you are paying on time. The golden number? Around 10%

If you stay between 10-30% of your credit utilization you will be in the best shape to increase your credit score. You want to strike the balance between having a payment history (35% of score) and not owing too much (30% of score). 

*Fun Fact: If you pay before your statement date, your balance doesn’t get reported to your credit bureau. Meaning, if you paid it all off, you would be reported as having 0% credit utilization. Best time to pay? Within a few days after your statement date. 

Length of credit history — 15%

FICO doesn’t consider your age when it calculates your credit score. The age of your accounts, however, is another story. Your length of credit history is worth 15% of your FICO Score. Statistics show that consumers with longer credit histories are less risky borrowers.

The idea is that with more data to work with, the results of the scoring model will be better, which helps a lender be more confident in its lending decisions.

So what do they look at when considering the length of credit history? The average age of your accounts, how long each account has been open, and the length of time since you’ve used each account. 

This is also why, you also shouldn’t close an older credit card - even if you aren’t using it. It still helps to bring your average history length up. 

For example, if you were a 30 y/o with 2 credit cards. One of which you got when you were 20 and the other at 30. The average length or age of your credit history would be 5 years.

10 years + 0 years/2 lines of credit = 5 years credit history.

However, if you were a 30 y/o with 2 credit cards. One of which you got at 25 and another at 30...the average length of your credit history would only be 2.5 years. 

5 years + 0 years/2 lines of credit = 2.5 years of credit history.

So the earlier that you get a credit card, the more that you can maximize the length of your credit history. 

Types of credit used — 10%

There are multiple different types of credit. 

Revolving, like a credit card, where you have a certain amount you get to borrow every month. 

Installment, which is set payments periodically to pay off a purchase, for example a car. 

If you have multiple types of credit, FICO may reward you with a higher credit score. Credit mix is only worth 10% of your score, so it’s not as influential, but still a good place for extra points. 

New credit – 10%

The final 10% of your Score comes from “new credit”. Essentially, if you apply for too much new credit in a short period of time you may be penalized, although it’s only short term, not permanent.

When someone requests a copy of your credit report from a reporting agency, a record of the access is added to your credit report. This record is called a credit inquiry.

Hard inquiries, or those that might damage your credit score, take place whenever you apply for new credit and the lender pulls a copy of your credit report. FICO considers the number of hard inquiries that appear on your credit report within the last 12 months.

Too many recent inquiries could be a sign of financial distress, basically that you are trying to borrow as much money as possible just to get by. You appear reliant on credit, and thus your score may decline.

This is super useful to know for when you are about to take out a loan for a big purchase. You shouldn’t open a new credit card within a few months of the purchase, or your score may decline temporarily, hurting you when you try to get that loan in the form of higher interest rates. Costing you hundreds, or even thousands across the life of the loan.

How to score high credit?

The easiest way to grow your credit score is opening a credit card the minute you turn 18.

The process is pretty simple, just go to your bank, and ask to open a card. This way, even if you don’t use it, you have a line of credit that is growing in age, allowing you to take advantage of the category: Length of Credit History (15% of your score). 

Once your card is set up you will want to set your card to automatic payments. This way, whenever your balance is due, your credit card company will transfer the appropriate funds from your bank account to pay off your balance. Even better, you can place subscriptions - like Hulu, or Netflix - on your card so you don’t even have to worry about purchasing something every month. Your automatic payments will boost your Payment History (35% of your score). 

Finally, aim to spend around 10% of your credit limit. This way you will prove that you only borrow a small amount, taking advantage of the category: Amounts Owed (30% of your credit). This proves that you aren’t reliant on credit but also that you pay it back every month. 

Get out there and grow that credit score!