I like to think as myself as responsible with money — especially since I’ve gotten older. I wasn’t always good with money. As a child, I was always so eager to spend my money at the 7-Eleven down the street from where I lived. I never saved a dime. Sure, I was young, but looking back I see a missed opportunity with regard to saving my money to this day.
Now that I am older and move in touch with my personal finances, I often talk a lot about personal finance with my friends and family. I’m usually the go-to person when people have questions about banking, credit cards, and what to do with their money. Chief among these topics are my conversations I have with folks about their credit score. With that in mind, I’d like to go over credit scores, why they are important, and what you can do to build or maintain your credit score today!
So what exactly is a credit score? Well, at it’s core, your credit score is a three digit number that represents your credit worthiness (i.e. how likely you are to pay back the people lending you money). It’s the adult version of getting a grade on a test. Credit scores are significant to you financial well-being because they dictate your ability to borrow money and under what terms you get to do so (i.e. the interest rate you are charged).
Diving deeper, the use of the word “credit score” is actually pretty vague. In fact, what people don’t know is that there are other forms of a credit score which are not widely available to you. For simplicity, we will talk about the credit score that everyone talks about when they use the word — and that’s your FICO score. Credit scores are calculated using information within your credit report. Those factors are:
• Payment history (35% of score)
• Total amount owed (i.e. credit utilization) (30% of score)
• Length of credit history (15% of score)
• Types of credit used (10% of score)
• New/recent credit (10% of score)
I’ll go over the five factors in a minute, but before I do, you should know that in the United States your credit score is provided by three credit bureaus: Equifax, TransUnion, and Experian). Credit scores are routinely updated and you can check your score at any time, for free, without impacting your score using Credit Karma (my personal favorite) or NerdWallet. I recommend you create an account today as they will regular update your score and provide you with notifications or changes in your credit report.
Now, onto the bulk of it…
The payment history portion of your credit report is exactly that: a history of how you payback your various financial obligations. As indicated above, it’s the largest portion of your credit report and the one that, if ruined, will require (mostly) time to fix. In this regard it’s important to keep the mindset that your past behavior will be used to make a bet on your future behavior.
Payment history, while also the biggest factor of your credit score, is also the easiest factor to explain: make your payments on time to boost your credit score. With regard to credit cards, it’s imperative that if you cannot pay the entire balance off every month, that you at lease pay the minimum payment due. Paying the minimum due every month, on time, will count toward an on time payment (but could affect your utilization if you decide to carry a balance).
Your credit utilization is defined as the percentage of total available credit that you have borrowed. Credit utilization is the second largest factor in determining your credit score. Much like payment history, this factor is pretty straight forward and can take less time to “fix.” Credit utilization will mostly correlate to the credit cards you hold as they are revolving credit tools and can be spent on, and paid down, at any time.
Let’s take an example. I have a $10,000 on my American Express Everyday Cash Preferred Card (apply and earn $200). Right now, I have an outstanding balance of $1,200. If this was my only trade line, my credit utilization would be $10,000 / $1,200 = 12%. Pretty simply, huh? Now say you have two credit cards: one with a $10,000 limit with a total spend of $2,000 and another with a $7,000 and a total spend of $1,000. In this example, the total amount of of credit available to you is $17,000 and your total spend is $3,000. In this example, your credit utilization would be: $17,000 / $3,000 = ~17%
As you can see from the examples, you can lower your credit utilization in a couple of ways: 1) pay down outstanding balances on your credit cards and/or 2) open another credit card to increase the available credit to you (apply caution here). Keeping your credit utilization low will indicate to lenders that you are serious about paying back what you owe. Finally, it should also be noted here that carrying a balance on a credit card subjects you to interest charges—which is the cost of borrowing money.
Length of Credit History
Length of credit history is defined as the amount of time each of your accounts has been open as well as the length of time since the an accounts most recent action (e.g. opening and/or closing accounts). This factor is the third biggest factor with regard to your credit score.
Due to the nature of this score, it is virtually impossible to achieve a perfect credit score when you are just starting out because increasing the length of your credit history, well, takes time. To this end, increasing your credit score when you don’t have credit means keeping your accounts open and paying a lot of attention to the other factors. When you do have an established credit profile, should maintain accounts for as long as possible and avoid opening too many accounts at various times.
Types of Credit Used
Your “credit mix” is the variety of accounts you have (i.e. credit card, auto loan, mortgage, etc.) This can be somewhat vague for folks, but to put it simply, obtaining and repaying a variety of credit products will have a positive impact on your score.
As I alluded to above, in addition or having various types of credit, it’s also important to make sure that all of those accounts are not new. Opening multiple credit products at the same time can have a negative impact on your score. In fact, opening new accounts will lower the average age of your accounts. The newer the account(s), the more this affects your credit score.
Checking Your Credit
In the age of technology, it’s become easier to check your credit in a moment’s notice. My personal favorite way to do so is by using the Credit Karma app, which is available on the web, on iOS, and on Android. It’s totally free and using it to check your score will not impact your credit.