A credit score is used to portray your creditworthiness. In a world full of consumers and borrowers, a credit score can make or break a deal with lenders. Starting out on your financial journey may compel you to borrow money for, say, a mortgage or student loan. But how much you can borrow and at what interest rate you are borrowing at is determined by your three-digit score ranging from 300 to 850.
Understanding the basic fundamentals of a credit score can be crucial when wanting to borrow money from potential lenders. They want to know how risky you are as a borrower and if they can trust you to pay them back.
Many apps will give you access to your credit score and will even provide a breakdown for you.
So what makes up this “credit score”? Read on to learn how credit bureaus calculate your FICO credit score along with my personal thoughts about each category.
Table Of Contents
- Payment History
- Credit Utilization
- Length of Credit History
- New Credit
- Credit Mix
- What’s in a FICO Score?
- Conclusion
Payment History
A history of late payments on loans and credit cards can be detrimental. Payments received later than thirty days are considered delinquent. Credit bureaus will be notified by your lender and the late payment will show up on your credit report. Accounting for at least 35% of a borrower’s score, this is single-handedly the biggest factor that influences your credit score.
Missing or being late paying a bill could stay on your credit for up to seven years. On the flip side, having a long healthy history of on time payments shows lenders that you are trustworthy.
MR. SIMPLE FI : I made sure to use a slight variation of the method described in “Automatic Millionaire” by David Bach simply known as “pay yourself first”. He explains it as automatically plugging away a portion of your income into a savings account for your personal use later. Essentially you are automating the process to happen whether you want it to or not.
Just set it up one time and let it ride. That’s exactly what I did, and continue to do, with our payments. I’ve designated our income to automatically pay every credit card, loan, or mortgage we’ve ever had in our name. This move takes the guesswork out of the equation. I can proudly say that we have maintained a 100% on payment history using it.
Credit Utilization
How much credit you use is the second most important aspect of your credit score. Maintaining a credit usage below 30% of your limit is considered “healthy”, as a general rule of thumb. The lower the usage the better with a caveat though.
Don’t aim to have zero credit utilization. While that sounds like a good idea, it means you lack the need for any new credit. Lenders want to see that you are actively using credit.
MR. SIMPLE FI : Trying to increase my credit limit while simultaneously keeping my utilization rate low had its fair share of challenges. To fix that problem, there was a “Catch-22”. Starting out, my credit threshold was very low.
Back when I had one credit card to my name, I utilized more than 30% at some points, not by choice of course. It worked out where I was able to decrease and maintain a lower utilization rate for a few months in a row. After a few successful months of controlling my utilized credit, I was able to request for my credit card company to increase my credit limit. They kindly obliged which lowered my utilization rate even more.
Contact your creditors and request a credit line increase. This is a great way to add to your total available credit. That way you decrease the chance of ever reaching the 30% level.
Length of Credit History
The longer your credit accounts have been established, generally the better it is for your track record. Your history is the age of all your credit accounts, oldest to newest, averaged out in age. Keep accounts open for as long as possible unless there is a necessary reason to close.
Equating to 15 percent of your total credit score, a longer credit history provides a better picture of long-term financial performance. Opening too many new accounts will decrease the length of credit history so avoid doing that if possible.
MR. SIMPLE FI : Daddy Simple FI convinced me to open a credit card back when I was 18 years old. That card has given me 15+ years of credit history and I plan to never close it even though it carries an annual fee.
Knowing what I know now, I would have chosen a zero annual fee credit card to start out with. If you’re just starting out your credit timeline, go that route first. Even if you don’t plan to use it often, charge it now and then to keep it active.
Another good tip is to cosign on a loan or become an authorized user with someone’s credit card. Practice caution with both methods as it requires trust from you to prevent any derogatory marks on someone else’s credit report.
“Don’t be upset by the results you didn’t get with the work you didn’t do”
New Credit
Opening new credit accounts in a short amount of time may pose as the borrower being too risky. It presents an even greater problem when their current credit utilization is fairly high to begin with. In addition to applying for new credit, a hard inquiry on your credit will drop your score a few points as well.
While only 10 percent is affected by new credit, having too many inquiries could suggest you are encountering financial difficulty by needing serious access to lots of credit. Try to apply for new credit accounts as needed and resist opening too many accounts too often.
MR. SIMPLE FI : While this has never been a major problem for my score, the major concern for me was while I was desperately trying to pay off debt, I applied for several credit cards with 0% balance transfer fees in a short window of time.
Reason was I wanted to maximize that limited window so the multiple inquiries would show as a single inquiry on my track record. Looking back, the hit on my score didn’t bother me much. But not knowing what that “window” of time was hurt my chances of opening new credit.
The lenders would see that I applied too often and would deny my application even with a 740+ credit score because I was looked at as a risky borrower which makes sense.
So word of advice, if you’re going to apply for several credit accounts, have all the applications open on separate tabs and apply for them all at one time. This should help prevent the problem.
Credit Mix
Making up the last 10 percent of your score, your credit mix or variety of debt tools indicate you, the borrower, can handle all types of debt. Lenders typically like to see a mix consisting of different types of credit accounts.
The more you diversify your credit, the more desirable you are as a borrower. But don’t open a loan just for the sake of diversifying your credit mix, that isn’t worth it. It isn’t necessary to have one of every type.
Types of credit include:
- Mortgage loans
- Auto loan
- Student loan
- Rental property loan
- Home equity loan
- Credit card debt
- Personal line of credit
- Home equity line of credit
MR. SIMPLE FI : Begin your credit history like I did and open up a credit card as early as possible, preferably with no annual fees, and hold onto it forever. Afterwards you can apply for other credit when appropriate to your situation. Lenders won’t deny you opening a student loan or auto loan, typically. They favor providing money for that type of credit more than a rental property loan.
I found this out when applying for my first investment property. The lender questioned my ability to repay them even though I had a signed lease for a tenant. The logic of a tenant paying the mortgage didn’t sit well with the lender. After some back and forth discussion, a six-month worth of cash reserves would satisfy their concern and we were able to close the loan.
Having this type of credit on my track record made it a lot easier for the next investment property. It’s the first one that usually gives you the hardest time.
What’s In A FICO Score?
Let’s recap the percentages of a credit score:
- Payment History — 35%
- Credit Utilization — 30%
- Length of Credit History — 15%
- New Credit — 10%
- Credit Mix — 10%
Improve your credit score by focusing on the big rocks like payment history and utilization. You can maintain a decent credit score with these two categories alone.
Conclusion
Simply being a borrower isn’t enough to improve your credit score. I hope that after reading this you can make sense of the five categories that make up your score and what you can do to improve them.
Remember, your score is most important when applying for credit. If you have no desire to borrow any money soon, then continue with what you’re doing.
But if you want to create a good impression on lenders, you now understand how credit bureaus calculate your credit score with a few actionable tips to take away.