Credit Score 101: Best Practices

What it Means and How to Improve it

Having a good credit score can be your key to financial freedom. You have access to the lowest interest rates for a mortgage, car loan, personal loan, business loan, and it might even land you that dream job! In other words, you save money and can make more money if you have a good credit score.

On the flip side, borrowing money with a bad score can end up costing extra money, which makes it harder to payoff outstanding debts and could limit the amount of money you can save and invest. Consequently, it can be difficult to improve your credit score once it’s been damaged. Time can be your biggest ally when it comes to building credit, but it can also limit how fast your score can improve. Nonetheless, there are tangible ways to improve your credit score, ultimately saving you time and money. In this article, we’ll define and discuss the factors that impact your credit score and how you can use them to your advantage.

In the simplest terms, your credit score quantifies your likelihood to repay debt. There are many different models that attempt to identify your credit score. We’ll focus on the FICO Score*, which is calculated using 5 key factors.

1) Payment History (35%)

The most heavily weighted credit factor is how you’ve handled current and previous debt. Your payment history looks at your number of accounts, late or missed payments, and other derogatory items such as judgements, foreclosures, bankruptcies, or collections. NOTE: having a balance on your credit cards is NOT a late or missed payment. Always make your minimum monthly payment on each card to maintain and improve your credit score.

2) Current Loan and Credit Card Debt (30%)

The amount of debt you have now is an indicator of what you can borrow (and pay back) in the future. A good goal is to use 30% or less of the credit that is available to you. Using 10% of your available credit puts you in the top threshold of borrowers. This category has the most volatility in the short-term. For example, we’ve helped clients boost their score by 20+ points by having them pay down credit cards to 30% of the card’s available credit. On the contrary, you might notice your score dip after you make a big purchase. Both of these examples are quickly reversible, which is unlike payment and length of credit history, which can take months to affect your score.

3) Length of Credit History (15%)

This category is straight forward, lenders want to know how long you’ve been borrowing money! Your score will reflect the age of your oldest account, the age of your youngest account, and the average age of all accounts. NOTE: Even if you don’t use it, keep your oldest account open so that it remains on your report in your favor. Using your oldest account can help boost your score even more.

4) Types of Credit Used (10%)

Diversifying your liabilities shows you can handle different types of debt. With all else being equal, a person with a credit card, a car loan, and a mortgage will have a better score than a person with 3 credit cards. Why? Because the first borrower has experience with both revolving and installment accounts.

Revolving accounts (i.e. credit cards) extend a line of credit to be used at your discretion and paid off at your discretion.

Installment accounts (i.e. car and home loans) have an initial balance to which you make fixed periodic payments (installments) to eventually payoff the debt in full; once the balance is fully paid the account is closed and the lender reconveys all rights to the borrower.

Limiting your credit accounts to either of these types of accounts can damage your score. However, it is not recommended that you apply for credit that you do not plan on using.

5) New Credit (10%)

The last factor brings up the most confusion when it comes to your improving your score. Quite obviously, you need to apply for credit to build up payment history and increase your available credit. However, applying for and opening new accounts will negatively affect your credit score in the medium and short-term. NOTE: Inquiries stay on your credit report for at least 2 years. It is a good goal to limit your number of inquiries during this period to 2 or less. Having no recent inquiries puts you in the top threshold for this category.

The type of account you are applying for also affects your score. For example, applying for 4 credit cards all at once will damage your score, while applying for 4 mortgage loans (within a 30-day period) only counts as 1 inquiry (provided you only receive one). Keep in mind that new credit types of credit have the lowest impact on your score and will eventually mature into seasoned, diverse accounts that will improve your score in the long run!

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Banks, lenders, and other creditors base their lending decisions on an applicant’s credit score (among other things). In fact, 90% of US creditors use the FICO score model when considering applications for credit (CNBC). In the mortgage world, the difference between good and bad credit can affect the rate and pricing by thousands of dollars over time AND upfront, respectively. With a single number having such an impact on most of your financial decisions, it’s good practice to ensure that you are doing what you can to maximize your credit score.

Federal law requires that consumers have access to at least 1 free credit report from each of the 3 bureaus (Experian, Equifax, Transunion) every 12 months. You can get your free report at creditkarma.com, annualcreditreport.com, or freecreditreport.com.

Once you know your score(s), beware that these agencies might solicit you to pay for credit boosts, which you do not need to do to improve your credit! You also have the right to dispute any negative report (inquiries, missed payments) that you don’t recognize with each of the three bureaus. Furthermore, you can put a “freeze” on your credit profile with each bureau to prevent any institution from pulling your credit, you can “unfreeze” at anytime.

If you or someone you know has further questions regarding credit scores, credit repair, or establishing credit, please get in touch with us!

Thank you for taking the time to read this article, we hope you found it helpful to your financial literacy and future success.

*Source: Wells Fargo. There are several variations of the FICO score model used for different types of credit. The FICO 9 model ignores past collections with zero balances, while the FICO 8 still takes these accounts into consideration. You can read more about the different types of FICO scores here.