Believe it or not, it’s not magic! FICO uses a specific weighting scale to put out your credit score.
With credit card debt increasing nationwide, and with the highest annual jump in more than two decades of 15%, I can think of no better time to discuss credit than now (1). Why do credit scores matter? Used for everything from house mortgages to credit card applications, a good credit score can save you significant money and stress. The easiest way to illustrate this can be seen in house mortgages. For example, a recent Zillow study showed that even between fair (620-639 per this source) and excellent (760-850 per this study) credit score, buyers can get over a 1.5% better mortgage rate (2). To put this in context, on a $400,000 mortgage alone, home buyers can save about $400 per month, which equates out to $144,000 in savings. While there are many different credit scores, we will focus on the FICO credit score, which is used by 90% of lenders (3).
The first and most important part of all credit journeys begins with your payment history. This looks at payments for credit cards, student loans, mortgages, etc., specifically checking to see if there are any late payments, and accounts for a whopping 35% of your credit history! (4). A single late payment can cause your credit score to drop by as much as 100 to 180 points (5,6). Even scarier? That late payment can stay on your credit report for up to 7 YEARS! (7). However, there are some reprieves. First, you can often have up to 30 days past the payment due date to pay, as lenders often wait that long to report to the credit bureaus, meaning as long as you make your payment before those 30 days, the delayed payment will not show up on your credit report (5). However, it would be best to pay ASAP, as well as double-checking with your lender to see how long it takes them to report to the credit bureau. In addition, even if they do wait 30 days to report to the credit bureaus, and you manage to make that payment, you will still likely be stuck with late payment fees and interest costs from your lender. A second reprieve that solves a lot of issues is to make sure to set all your payments to auto-pay. One benefit of credit cards is that you can set the auto-pay to only do the minimum payment, and that way there is less risk of over drafting from your bank account in case you don’t have enough for the entire balance, but it still keeps you paying on time. A second benefit of autopay, at least in my experience with private student loans, is that it can often lower your interest. For example, my private student loan through Earnest allowed me to drop my interest rate by 0.25% by authorizing auto payments from my bank account. While this may not seem like much, for a $10,000 loan paid off over 10 years with a 5% interest rate and making monthly minimum payments of $50, you would pay $12,727.70 over the 10 years, versus $12,581.65 with the 0.25% decrease to 4.75%. While $146.05 over 10 years doesn’t seem very significant, think how much this could increase with larger student loans, such as those for grad school, med school, or even just private undergrad. And any savings for something as simple as allowing auto pay, even if you’re someone who never forgets to pay, is easy money you get to keep. And if auto-pay is not for you, there are many other ways to make sure to keep up with payments. You can set reminders for yourself (in your phone, on a whiteboard, sticky notes, etc.), schedule all payments to be at the same time every month to make them easier to pay off all at once, pay them off as you go (specifically for credit cards, to build credit while making sure you have sufficient funds to pay for things), or any other way you are able to keep yourself accountable to make on-time payments.
To summarize, with payment history being the most significant component of your credit score at 35%, making sure to pay all payments on time is the most critical factor in anyone’s credit journey, no matter where they are at.
While payment history is the largest element of a credit score, credit utilization is nearly as essential to consider. Credit utilization (making up 30% of your credit score) is the amount of debt you have versus the amount of credit you have available to you (4). This is most prevalent with credit cards, as you will have a credit limit that you need to stay under, and you would ideally keep your amount of debt to a maximum of 30% of your credit limit, with lower than that being even better (8). For example, if your credit limit is $1,000, you should ideally keep the amount of charges on that card, as well as any accrued debt and interest, below $300. And as mentioned above, keeping it far below $300 is even better! However, there will obviously be times when you will need to make large payments, whether that be in emergencies, for travel, or a whole variety of other situations. In these cases, I use a couple of ways to stay under the 30% credit utilization to the best of my ability. First, making sure to request credit limit increases at least every 6 months, or with any new income changes, is an excellent way to lower your credit utilization. For example, that $300 with the $1,000 credit limit now becomes a credit utilization of 20% instead of 30% if you are able to raise your credit limit to $1,500. However, you also need to make sure that you won’t begin spending more simply because you have a higher credit limit! If you are already someone who gets close to maxing out your card every month, this may not be the best idea. A second way to lower your credit utilization is to maintain multiple credit cards. With multiple credit cards, you can spread out your purchases amongst them and have a higher total credit limit to maintain a lower credit utilization. To again use the $1000 credit limit as an example, if you are buying $300 worth of items but are able to spread them equally over two credit cards, $150 a piece, that both have credit limits of $1000, your credit utilization suddenly jumps from 30% to 15%! However, this comes with a major warning: if you are not yet comfortable paying off, managing, and understanding one credit card, going to two or more credit cards will potentially exacerbate any current problems, making any increases in credit utilization redundant and often leaving you worse off.
Overall, the easiest and safest way to increase your credit utilization is to either find ways to spend less or to raise your credit limit, but options such as increasing the amount of credit cards for responsible users may also work.
With payment history and credit utilization making up a combined 65% of a credit score, the last three factors may seem unimportant. But understanding and abiding by them could be the difference in getting your score to where you want it to be! The largest of the three final items is the length of your credit history, accounting for 15% of a credit score (4). This allows a lender to see the type of borrower you are over a longer time period, making you a safer option in their eyes if you have a history of good credit. In addition, this number is the average age of your credit. For example, if one credit card is 6 years old but you just opened a new card a year ago, your credit history is an average of 3.5 years.
The aspect of increasing your credit history length is why it is so important to begin your credit journey early, to maximize your time along the way.
The last two parts of the credit score calculation each come in at 10% (4). The first one is the amount of new credit requests that you have had. This one affects your credit whether you use it or not, as long as it is a hard request. A hard credit request is when your credit is checked by a financial institution as part of a process for applying for a new credit card or loan, while a soft credit check oftentimes is a part of a background check and doesn’t affect your credit score (9). I learned this process the hard way, as in the process of applying for different student loans, there were a variety of hard credit inquiries on me that hurt my credit a significant amount. Even though I didn’t even end up using any of those loan options, those credit inquiries were enough to drop my credit score a fair amount.
Therefore, making sure that the credit inquiry will be for something you need and will definitely move forward with is very important.
The final aspect of your credit score, and at another 10% of it, is your mix of credit (4). This simply means that a lender will look at the various types of credit you have, such as credit cards, mortgages, various loans, etc. Being able to manage all these different types of debt will make you appear knowledgeable and safe to many lenders.
Finally, I will leave you with a short to-do list for your credit journey:
- Start early! Open a credit card when you turn 18, and do something simple such as only using it for gas, and make sure to pay it off FULLY every month.
- Set up autopay for all your accounts, potentially only setting it for the minimum payment so you don’t worry about over drafting from your bank account, just in case you forget to pay.
- Check your score! You can do it for free at experian.com
I hope you learned something! Always feel free to shoot any further questions into the comments section!