What’s your credit score? Is a question that is just not asked that often. It’s almost like asking someone their annual salary. Its a rarely discussed topic, that when brought up, feels a little like scratching your underbelly.
With the invent of Credit Karma, consumers are generally more aware of their credit score. I’ve rarely ran into anyone who has no idea of their credit score. But pinning down what it is exactly, and how it is calculated, is still a gray area for most people.
Wikipedia describes credit as “the ability to obtain goods or services in advance of payment.” Well said Wikipedia. So how does a company, industry or entity determine if they should give you goods or services before you pay for them? That’s where your credit score comes in.
There are five main factors that go into your credit sore:
- Payment History
- Amounts Owed – Utilization
- Length of Credit History
- Credit Mix
- New Credit
We’ll review each in detail. But first, a bit of context. The most widely used credit score is the one published by Fair Isaacc and CO (FICO). There are others, but they are the jeggernot in the industry. Most creditors will look at your FICO score when making a credit decision. A FICO score is comprised of three reporting agencies: Experian, Transunion and Equfax.
Payment history is weighted ast 35% of your credit score. Payment history is simply a running tab of weather you’ve paid your bills on time. Late payments will negatively affect your score, and generally stay on your report for seven years. I say generally because creditors have to pay to report to the credit agencies. We’ll do a deeper dive on this in a future post, so for simplicity sake, let’s assume a late payment will stick around for seven years.
A few late payments won’t tank your score overall, but they will negatively affect it. Since payment history is the most heavily weighted component of your credit profile, it stings the most when there is a black mark.
FICO is generally secretive about their model, and how exactly one component affects the whole. But they go into a fair bit of detail on what affects payment history. At MyFICO.com, they outline; the types of accounts that affect the payment history calculation, they types of collection accounts and public records that affect you and the details of delinquencies and how they affect the credit score.
The moral of the story is make payments on time on teh accounts that apprear on your credit report.
*Practicality Note: If you find yourself in a cash crunch one month, and you care about your credit score, and have just enough money to pay either the minimum payment on your credit card, or buy groceries…..eat Ramen. Pay the credit card minimum payment so you dont’ have a late payment following you around for the next seven years.
Amounts Owed – Utilization
This is the sum total of how much you currently owe creditors. Owing money in and of itself is not a bad thing. This component of credit negatively affects your credit scores when a high percentage of your available credit is being used. This indicates a person is overextended. The general rule of thumb is to never use more than 30% of the credit you have available to you. So if you have a credit card with a $1,000 credit limit, never, at any time, charge more than $300 on that card (30%*$1000=$300).
The type of account with high (or low) utilization makes a difference. Amounts owed on installment loans and revolving trade lines affect the score differently. The 30% benchmark above, is generally attrributed to revolving accounts. Generally credit cards that you can charge and pay each month.
Installment accounts, however, are loans you taken out and agree to pay over time. If you borrow $1,000 with defined terms to pay an amount per month for a set number of months will increase the score. Given of course you make the monthly payments on time (see above).
Length of Credit History
In general, a longer credit history will lead to a higher credit score. Most of us have heard it said not to close old accounts. This is where that comes into affect. The calculation that informs the length of credit history portion of your score is average age of accounts. That’s calculated as follows:
(Age of Tradeline #1 + Age of Tradeline #2) / # of Tradelines
Let’s look at an example. If you have two credit cards. Card #1 you opened 10 years ago and Card #2 you opened 5 years ago. Your average age of accounts would be:
10 years + 5 years/ 2 cards or 7.5 years.
If this same person closes Card #1, the older of the two cards, the math looks like this:
5 years/2 cards = 2.5 years
Remember, Card #1 will stay on your credit report for seven years (or more). So it is still pulled into the calculation. By closing the older card, you’ve effectively reduced the length of your credit history.
This refers to the mix of credit accounts, installment loans, finance company accounts and mortgage loans you have. It’s not necessary to have one of each, and I don’t advise you to open an account simply to diversify your credit report. Without the intention to use those accounts, or without a bonified need for that Tradeline. This is among the lowest contributor to your credit score. Credit mix makes the most difference on a credit report where there is little to no credit.
A large number of new accounts can be a red flag to a lender. A large number of new revolving accounts is considered risky because the creditors don’t know how you are going to use that credit. It takes a while for your credit behavior with the new accounts to become apparent. Generally, opening a new account will pull your score down before it goes up. New accounts is portion of your credit report that is affected by inquiries. It’s been said that inquiries will pull your credit score down. That’s true, they will but the impact is usually minimal. Inquiries stay on your credit report for 24 months, BUT they only impact the score for the first 12 months.
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