Whether you like it or not, credit and our credit scores play a big role in our day to day life. Anytime you need to finance something, get a new credit card, buy a house, move to a different apartment, start a new service with a phone or cable company, etc, your credit sore will be checked. A person’s credit score tells so much about a person and if they are a good candidate to lend money to. Banks use this score all of time when it comes to making decisions. So it would be in your best interest to really know this stuff.
The FICO score itself is an algorithm that was developed to figure out how trust worthy someone would be. While there are other types of algorithms out there, such as the Vantage 3.0 score, most financial institutions exclusively used the FICO score.
The Score itself ranges from 300 all the way to 850. The breakdown can be seen below:
- 300-579 Very Poor
- 580-669 Fair
- 670-739 Good
- 740-799 Very Good
- 800-850 Exceptional
While it’s nice to be able to say your score is “very good” vs “fair” the titles don’t matter that much. And really, if you want to truly get the best rates for things, there isn’t much of a difference between the rates for someone with a 750 credit score vs an 850 credit score. 750 is all you really need to shoot for to get the max benefits and the best rates.
What is the Score Made Up Of?
So now we know the range of scores, and how each range is broken down. But what is the score itself made up of? The score is made up of 5 different categories: payment history, credit utilization, length of credit history, new inquiries, and finally, credit mix.
Payment History: 35%
What is the best way a lender can tell if you’re a trustworthy candidate to lend money to? If you make your payments, and if you make them on time! And that’s the reason it holds so much weight on your score.
The way it works is pretty simple. Every month that either your credit card, or any other loan r financial obligation is due, you’ll need to make that payment. The financial institution then reports if that payment was made. If it was, you’ve made a successful payment, if it wasn’t paid, then it counts against you. If you had to make 100 total payments, and missed one, you would be 99/100, or 99%.
As you are required to make more and more payments, that 1 missed payment will impact you less and less. Assuming you made 100 more payments and didn’t miss any more, you would be at 199/200 or 99.5%
Having 97% or less is considered bad, 98% is ok, but you really want to be in the 99-100% range.
Credit Utilization 30%
The next biggest factor in determining a credit score is the utilization, or how much debt you have relative to how much credit you have available. There are actually 2 parts to this. The first is how much total debt you have, relative to your total available, and how much debt you have in each account, relative to how much is available for that account.
The utilization ranges are broken down as follows:
- 0-9%: Ideal
- 10-29: Good
- 30-49%: Alright
- 50-74%: Bad
- 75%+: Maxed out
As you can see above, once you’ve reach 75% of your available credit, as far as FICO is concerned, you’re maxed out. Ideally, we want to have less than 9 percent utilization. This applies to both our total available credit, and to each different card. Luckily for us, once you do pay down some debt, the utilization updates immediately, and has no “memory”. If you managed to pay down debt from 80% to 5%, your score would only reflect the 5%, and there would be no penalties now for having that high 80% in your past. The inverse is also true, if you rake up debt quickly, your score will also drop right away, with no reward of having a low utilization earlier.
Here’s an example. Say we have 3 credit cards, 1 with a limit of $5,000, 1 with $3,000, and the other with $2,000. Our total available credit is $10,000. Now lets say we put some debt on those accounts like so:
- $2,000/$5,000 (40%)
- $2,000/$3,000 (66.66%)
- $2,000/$2,000 (100%)
- Total: $6,000/$10,000 (60%)
In the scenario above, we have $2,000 on each card, so our total utilization is $6,000/$10,000 or 60%. However, we also have to take into account each different card. Even though the amount on each card is the same, it reflects differently because we have a different limit on each card. The card with the $2,000 limit is maxed out, vs the card with a $5,000 that is only at 40% range.
Ideally, we want 9% or less on our accounts. So that would end up looking something like this:
- Total: $900/$10,000 (9%)
- $450/$5,000 (9%)
- $270/$3,000 (9%)
- $180/$2,000 (9%)
Length of Credit History 15%
From here on out, the categories are not weighed as heavily. The first 2 made up over 65% of your score! However, the rest are still important too, especially for those of you that want to max your score.
The next category is length of your credit history. Just like utilization, this is broken down into both, how long your credit history goes on for, and how long each account has been active. The breakdown is as follows:
- Less than 2 years: Bad
- 2-4 years: not great
- 5-6 years: alright
- 7-8 years: good
- 9+ years: very good
For the overall credit history, the average age of all of your credit accounts is calculated. For each account, the age is taken for how long its been open. The more accounts you apply for, the lower your average age becomes. However, the more cards you have, the less impact opening a new will have on your average age of accounts.
As an example, if you’ve the same 3 cards, but they looked like this:
- Card 1: 5 years (60 months)
- Card 2: 2 years (24 months)
- Card 3: 6 months
The Average age of all of your accounts would be 30 months, or 2.5 years.
New Inquiries 10%
For this, keep in mind there are two different types of inquiries, soft vs hard. Soft inquiries do not impact your score at all while hard inquiries do. Anytime a hard inquiry is conducted on our account, it is added to the list. The hard inquiry itself will impact your score for a total of 1 year, and will stay on your report for 2 years, after that, it is gone forever.
- 0 Inquiries: Great
- 1 Inquiry: Good
- 3-4 Inquiries: Alright
- 5-8: Bad
- 9+ Inquiries: Very bad
In general, when you are applying for a credit card or getting a loan through a bank, only 1 hard inquiry will be conducted. However when you are car shopping or looking into buying a home, it’s very possible that many hard inquiries will show up on your account. Luckily for us, FICO realizes that these hard inquires are most likely from the same event (looking for 1 car, and 1 home). In this case, any related hard inquiries within 30 days will show up on your report, but will only be scored as 1 new inquiry.
Credit Mix 10%
Last but not least is credit mix. The FICO algorithm likes to see that you can handle different types of accounts, and will score you better for it. But please don’t open unneeded accounts to boost your score, it wont make much difference. While it’s included here as 10%, it’s more so intended for lenders to judge an applicant if they do not have much else in their account to work with.
The different types of accounts you can have are credit cards, retail accounts, installment loans and real estate mortgages.
Improving Your Score
It would be a disservice if I didn’t briefly how to improve your score. Generally speaking, if you have less than a 700 credit score, there’s something on your report that’s bringing that score down. You’ll have to analyze your report, and see what that bad mark is.
Obviously, the two biggest factors in a credit score involve payment history and utilization. If you have an issue with either one of these two categories, fixing them will have the greatest impact. If you happen to have late payments, then making more on time payments will (slowly) bring up the score for that section. Alternatively, seeing if you can remove that late payment from your credit report would also go a long way to improve that score. For those things that you can’t remove, late payments will disappear from your credit report after 7 years.
If you have a lot of debt, that can also drag your score down too. Paying it down will quickly improve your score. If maxing out your score is your primary concern, focus on your accounts that have the highest utilization. If you have multiple accounts with high utilization, collectively bring them down to the next threshold until they are all sitting lower than 9%. Having those accounts lower than 9% will have a huge impact on your score!
For everything else, I would say don’t worry about it unless you’re concerned with getting an absolutely perfect 850 score. But realize that the maximum benefits come from having a 750+ score. If your credit age is too low for your liking, don’t apply for any new cards or accounts. Ideally though, the thing to do would be to apply for many accounts as early as possible, so if you want to add a new one, it wont impact you that much. With every month, your average age will go up, so no sweat there.
Hard inquiries will come and go quickly, and they are just a necessary evil. As long as you can either get a new account or a new car/home from them, they are always worth it. Finally, credit mix also comes into play. If you happen to have a credit card, with either a student loan or a mortgage, you should be good to go on this front. If you don’t have anything at all, consider taking an installment loan of a small amount, say $500, and pay most of it back immediately. After that, you can pay the minimums and it will stay showing on your credit report until you pay it all off. Again, this is only if you have absolutely no accounts. By no reason will they help your score that much.
The FICO score is just a very important part of American life. Because it has so many far reaching impacts, it’s important to do what you can to have a good score. Doing so will pay for itself many times over in the amount of money you can save vs if you didn’t have a good score!