You probably know that there’s a mysterious number tied to your identity called your credit score. I say it’s mysterious because like most people, you probably aren’t sure exactly how it was determined, what it means, if it’s important, or what you can to do make it better (and why you want to)!
When it comes to managing your personal finances, it’s important to understand why your credit score matters and why it’s important as well as what you can do to improve it (or ensure it stays high if you already have a good one).
Your credit score (or FICO score) is a number that tells the bank how risky it will be to loan you money. The higher your score, the more likely you are to get a loan. Similarly, the higher your score, the lower the interest rate you’ll be eligible for.
FICO is the company that specializes in “predictive analytics” – they look at your credit history and try to predict how you will behave, financially. Here’s the thing – you can learn about what affects your score and what you can do to improve it, but there’s not an exact formula for figuring it out; you’re never going to be 100% sure how FICO came up with the number. The exact science is a bit of a mystery. Fortunately there are factors to consider and behaviors you can model that will help you improve your score.
WHY YOU SHOULD CARE ABOUT YOUR CREDIT SCORE
Your credit score matters most when you are buying a home or a car and need to get a loan. If your credit score is higher, you will get a lower interest rate, so over time the purchase will cost you less. The bank allows you to pay less interest each month because they believe you are financially responsible and you will be able to repay the loan without defaulting (missing a payment). When your credit score is low, the bank hikes up the interest rate, charging you more interest, because they fear you may have trouble making payments. They are trying to protect themselves, but it’s kind of backwards, isn’t it?
Basically, you get rewarded for being more “responsible” (if you have a higher score), by paying less interest. It’s worth paying attention to the things that factor into creating your score and trying to get it as high as you can.
THE 5 FACTORS THAT ARE USED TO CALCULATE YOUR CREDIT SCORE
According to FICO there are 5 factors that are used to calculate your credit score. Let’s explore each one, what they mean, and how you can influence your rating in these areas.
Your payment history refers to your past behavior paying your bills. Payment history makes up about 35% of your credit score (the largest amount!). If you always pay student loans and credit cards on time, FICO will reward you with a higher score in this area. FICO looks negatively at late and missed payments and if you have these on your record, FICO lowers your score. Here’s where the mystery lies – you never know exactly how much one late or missed payment will affect your score. The best way to improve your credit in this area is by making consistent, timely payments.
FICO is looking for you to have ample credit available to you, but the catch is that you shouldn’t be using nearly all of what’s available at any given time. Credit utilization is measured both individually by card and also across multiple cards, and it makes up 30% of your FICO score. There’s no hard rule here for how much credit you should have and use. In the past it was recommended not to carry a balance higher than 30% of the available limit on any one card for an optimal credit score. That’s still a great practice, but it’s not guaranteed to help you get your score as high as possible. There are several factors in credit utilization that play into your score:
How many credit cards do you have?
Are any of your cards maxed out? If not, are you using half of what’s available to you? Less than 30% of what’s available? Less than 10% of what’s available?
How much do you owe on each of your cards?
What’s the total amount that you owe on all of your credit cards?
Since there’s not an exact formula to get your score as high as possible, the best practice for credit utilization is to carry low balances on the cards you have (and to still have credit available to you, should you need it).
LENGTH OF CREDIT HISTORY
The length of your credit history plays into your FICO score at about 15%, and longer credit history is better than only having a short history. This is an important component and one that many people mistakenly overlook when they are trying to clean up their credit. For example, if you have an old credit card that you opened ten or twenty years ago but haven’t used, you should continue to keep this credit card open (with a zero balance) rather than closing it out completely. By keeping a card you have had for many years you increase your length of credit history, which positively affects your FICO score.
New credit accounts for 10% of your FICO score, but opening lots of new cards does not lead to an improved score (in fact, it will likely result in the opposite because it sends the message that you need additional money that you don’t have). The best practice for new credit is to open new cards only when you need them and pay them off right away.
The final component of your credit score is based on the assumption that you have a good credit mix. If you have a good credit mix then you have a variety of types of loans and you are able to repay them all. There are 2 types of loans: revolving and installment loans. Revolving loans (for example, credit cards) aren’t based on a predetermined amount for a loan, these loans allow you to make charges, pay them off, then make charges again. Installment loans are loans that you get in a lump sum and make payments on each month (such as a student loan). If you have both types of loans and pay them off in a timely manner with no late payments, that’s great! It’s not recommended to go out and get loans to increase your credit mix since it’s only 10% of your FICO score.
Credit scores are confusing and since there’s no perfect formula to getting the highest possible score, it’s important to take these 5 factors into account as you build your credit as an adult. Not sure what your score is? I recommend using annualcreditreport.com once a year to pull your report for free. There are a lot of sites out there to choose from – this one is reliable.
Stay tuned for the next post about credit: What NOT to do when you are trying to improve your credit score.