Chapter 3: Credit Scores – What’s the BFD?
Now that we’ve covered the history of FICO© and we’ve learned about credit scores and credit history reports, let’s pull back the curtain and take a look at how the sausage is made.
What makes up your Credit Score?
There are five raw ingredients:
- Payment History
- Credit Utilization Ratio
- Length of Credit History
- Types of Credit
- Number of New Accounts
Not each ingredient carries the same weight – as you can see in the handy, dandy pie chart below.
As you can see, some ingredients carry more weight than others. Also, you have direct control over several of these inputs. Others, not so much. The good news is that the most valuable inputs (those that count the most toward your score) are also the inputs that you, as a consumer and credit user, have the most direct control over. And the time frame is the shortest — meaning a shorter gap between changing behavior and seeing those changes reflected in your score.
All that to say: there are (relatively easy) things you can do right now that will have a large impact on your credit score.
Payment history (credit score value: 35%)
Payment history is the credit score ingredient that carries the most weight and has the shortest time frame (quickest impact).
It’s also an element that you have total control over.
Don’t be lulled by the obviousness of this ingredient. Yes, payment history refers to… um, your history of payments. But the issue is more nuanced than it might first appear.
They’re looking for:
- Do you have a record of activity?
- Do you make a payment every month or have you skipped payments?
- Do you pay on time?
Remember, being credit invisible can impact your financial life in the same ways that having bad credit can. So it’s not only a question of “are you paying on time” but also “are there any payments being made at all?”
Credit scores are supposed to be a quantification of your creditworthiness. The best way to demonstrate creditworthiness is have documented proof that you pay your debts.
There are several easy and effective tricks and habits you can use to improve your payment history and boost this portion of your score in the next section.
Credit Utilization Ratio (credit score value: 30%)
Your credit utilization ratio is also referred to as your debt-to-credit ratio.
current account balance(s) ÷ credit limit(s) = credit utilization ratio
In plain language it means, “How much do you charge to your credit cards in comparison to the total amount you could charge on your cards?”
If you have one credit card with a credit limit of $1,000 and your account balance is $100, then your current credit utilization ratio is 10%. You’re currently using 1/10th of the total amount you could use of your account’s revolving credit.
$100 ÷ $1,000 = 10% (used)
In very simplistic terms, you should strive to always keep your ratio below 30%. Thirty percent is considered the tipping point — anything over that will actively hurt your score. But there are nuances to consider. And the more you know, the more your score will grow.
Although utilization above 30% will actively hurt your score, 0% isn’t optimal either. Zero utilization won’t actively hurt your score but nor is it actively helping or building your score (think “credit invisible”). The best rule of thumb is to strive to always stay 20% or under — and the lower the better. If you really want to maximize this portion of your credit score, try to stay in the single digits (between 1 – 9%).
In terms of value or importance to your credit score, your credit utilization ratio provides the second-biggest bang for your buck. It’s not quite as important as your payment history — and it’s not quite as easy to control or directly impact.
The main reason your debt-to-credit ratio isn’t as simple to control as your payment history is due to the revolving nature of credit credit cards. Depending on where you are in the billing cycle and grace period and whether or not your latest payment has been processed, your credit ratio could be 100% one day and 0% the next.
The good news is that, generally, credit card companies report credit activity to the credit bureaus a few days after issuing account statements. That means for most people in most situations it’s safe to base your credit-maximizing decisions and habits on ratio calculations using your statement balance instead of sweating over your utilization ratio on a continual basis.
statement balance ÷ credit limit = credit utilization ratio
There’s another nuance (complication) to consider: if you have multiple credit card accounts, the total of your balances and your credit limits are considered. While the card you use most frequently may tend to exceed the 30% utilization red-zone, a second card’s unused available credit could bring your total utilization ratio down into the safe zone.
As an example, if you have two cards and each has a $5,000 credit limit, your ratio will be based on $10,000. If Card A has a balance of $1,500 (individual 30% utilization) and Card B has a $0 balance (0%), your total utilization ratio would be 15%.
$1,500 ÷ $10,000 = 15% (used)
Let’s consider a different scenario: Card A has a credit limit of $5,000 and a balance of $2,000 (40%) and Card B has a credit limit of $10,000 and a balance of $100 (1%). In terms of assessing your credit utilization, FICO© would read it as 14%.
$2,100 (used) ÷ $15,000 (total) = 14%
One final consideration: time. FICO© occasionally changes the rules and their latest change had to do with how many months they consider when evaluating your utilization ratio. Before the changes, they only checked your ratio as it stood at that point in time. That meant you could regularly use 30% or more of your credit on a regular basis and then, just before submitting a credit or loan application, you could clean up your act with no one the wiser. Like your room. It might be messy 364 days out of the year but as long as it’s clean on the one day someone visits, everything’s good. But now FICO© considers your ratio history. It’s not good enough to pay down to balances just before asking for a new loan; now you need to show that your ratio is consistently under 30%.
There are several ways to reduce your utilization ratio and improve this portion of your credit score in the following section.
Length of Credit History (credit score value: 15%)
Unlike the three previous credit score ingredients, this is one where you have very little direct positive impact. It takes a full 10 years to build 10 years’ worth of credit history.
There are no shortcuts.
However, there are some important strategies to keep in mind for ensuring a long history and a few destructive practices to avoid. Those are covered in the next section.
Types of Credit (credit score value: 10%)
If you recall from Section 1.1 – Basic Terminology, there are three general types of loans: installment, revolving, and mortgages.
The most common type and the one I’ve discussed in this guide is revolving credit in the form of credit cards. It is possible to build and maintain an excellent credit score with only this one type of credit in your credit history. The added advantage is that, as long as you do it right, it’s possible to build an excellent credit score — and never pay a single penny in interest.
However, demonstrating creditworthiness by borrowing and paying back other types of loans would add a level of depth to your history and would improve your score even further.
Should you borrow money and pay interest just to build history of two types of credit instead of just one? That would depend entirely on the circumstances but taking on a loan you don’t need and paying interest just for the sake of building credit…. (shrug)
In the next section, I cover a few options and scenarios where the advantages of adding depth to your credit-type portfolio might outweigh the disadvantages of taking on debt and paying interest.
Number of New Accounts (credit score value: 10%)
Each of the previous four ingredients has the potential to benefit or hurt your score.
New accounts only have the potential to hurt your score. A lack of new accounts won’t boost your score. [A lack of new accounts might translate into accounts with long histories — a metric that will improve your score.]
A new account signifies new debt (or at least the potential for new debt). And it makes sense that potential creditors would want to know how much other new credit you’ve applied for or how much debt you’ve taken on recently.
And “recent” seems to be a very relative term for creditors. New credit card accounts and loans will generally show as “new” for 3 years after you open them.
Those people you know or read about who are constantly churning credit cards to earn bonus rewards could be hurting their credit scores in two ways: they always have “new” accounts on records and, if they’re closing the accounts after cashing in on the special offers/bonuses, then they’re not building long credit histories (see Length of Credit History above). Although Length of History and New Accounts only represent 15% and 10% of your score (respectively), together they account for 25% of your total credit score. Constantly opening and closing cards would certainly impact your overall credit score.
In the next section, I cover some points to consider when you’re weighing the pros and cons of opening a new account.
Bonus Ingredient: “Dings”
So what about “dings?” Those mystical, mythical little hits that are constantly banging up our credit scores? We’ve all heard of them, haven’t we?
Although lenders compete against each other they also work together to protect their collective interests. Lenders want to know who else is competing for your paycheck. And potential lenders don’t only want to know who else you’ve already borrowed from — they want to know who else is even thinking about lending you money. So each time a lender makes a credit inquiry, they leave a little note for other lenders that they’ve they’re considering giving you a loan.
These little notes are often referred to as “dings” but the technical term is “credit inquiry.” There are two types of credit inquires: hard inquiries and soft inquires.
Hard inquires are credit requests from lenders in response to applications you submit. When you fill out any type of loan application — credit card, car loan, mortgage, store card, home equity line of credit, student loan — the lender is going to check your credit to see who else you’ve borrowed from, how much you’ve borrowed, whether you pay on time, etc.
These are hard inquiries because they indicate the potential of financial obligation on your part. You intend to borrow more money from someone.
A hard inquiry results a hard ding to your credit score. So each new application that you submit will result in a hard ding to your score. Your score will go down a few points with each hard ding.
Soft inquiries are credit requests that either a) activity you’ve initiated that won’t result in a new loan or b) aren’t in response to an application you filed. Examples of soft inquiries (soft dings) are job applications, apartment or home rental applications, and all of the non-solicited credit card offers you receive in the mail.
Soft inquiries are, well, soft. They’re called soft dings but they don’t actually impact your score. These inquiries are soft because the inquiring entity is checking your creditworthiness and your current monthly debt obligations but they won’t be extending you credit as a result of the inquiry.
Hard inquiries will ding your score a few points and the impact will last about a year.
For better or worse, your credit score is a reflection of your credit activity. Your score is made up of five subcategories or ingredients representing your payment history, how much of your available credit you use, how long you’ve been using credit, the types of credit you’ve used, and how recently you’ve applied for new lines of credit. Some ingredients count more than others. And you have a large degree of control over each ingredient though some are easier than others to manipulate over a short period of time.
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