You’ll specifically use this article in Step 2 of The 9 Steps to Financial Freedom. However, it’s beneficial in all steps.
Oh the wonderful credit score.
I am not “in love” with the credit score and what it stands for. However, I realize that it’s something that affects some of the most major financial decisions that we make in life. In that light, it means that everyone should know how it is calculated and what things can affect the score itself.
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Before we get into the details, you should have a clear understanding of what your credit score is. First, there are currently a couple different types of credit scores. Two of the popular scores are the VantageScore and the FICO score. The most utilized and the one we are going to focus on today is the FICO score.
Your FICO score is calculated utilizing information from the three major credit bureaus (Equifax, TransUnion and Experian). The score ranges from 300 -850 (the higher the better) and it is used by most lenders before issuing credit. Lenders may utilize your FICO score in conjunction with others items such as your income.
The FICO score is calculated by looking at your history utilizing credit and by reviewing certain aspects of said history. So without further ado, let’s take a look at what items are used to calculate your credit score and what factors affect it:
Payment History (35%)
The biggest chunk of your score is based upon your payment history. To put it simply, if you don’t pay your bills on time, it hurts your score.
The credit agencies will review the payment history on a number of accounts that you may have open. It will certainly include your credit cards, mortgage, vehicle loan, other installment loans, etc. They typically view the accounts as current, 30 days past due, 60 days past due and 90+ days past due.
Bankruptcies, liens, wage garnishments and other judgements will also affect this area of your credit score. In fact, bankruptcies will stay on your credit report for up to 10 years. Therefore, it should only be used as a last resort.
Possible Action Items:
- Pay your bills by the required due date (even if it’s only the minimum)
- Use automatic payments on your installment loans (mortgage, vehicle, etc.) to ensure they are paid on time
- Use Google Calendar to create reminders (email and text messages) for payment due dates
- If you accounts are delinquent, call the companies to see if you can bring them up to date without it being reported to the credit agencies
Amounts Owed (30%)
One of the major focus points in this section is credit card debt. Other areas such as mortgage debt, student loans, etc. are accounted for in this section but do not weigh as heavily on the score as credit cards do. Therefore, it’s in your best interest to keep the balances on credit cards within certain limits (I recommend 25% of available credit).
Possible Action Items:
- Since credit card debt is a major focus in this section, it’s in your best interest to pay these down first
- Get your credit card balances below a threshold of 25% of available credit (i.e. if you have a $10,000 credit limit, try and keep your balance below $2,500 at all times)
- Do not go over your available credit limit
- As you continue to pay your bills on time, your credit utilization ratio will decrease and thus increase your score
Length of Credit History (15%)
Just as the title suggests, this section of the score looks at the length of your credit history. So, the longer you have used credit, the better your score in this area. This is why people generally recommend getting a credit card early on and paying the balance in full each month as this will establish a credit history for you.
Possible Action Items:
- Have someone with a long (and great) credit history add you as an authorized use on their account (they don’t even have to give you the card to use)
- Do not close older credit accounts as it may hurt your score (if you have a problem using credit cards responsibly, keep the account open but cut up the card, put it in your freezer, etc.)
Types of Credit (10%)
This part of your score will account for the different types of credit you have open. The credit bureaus want to see that you can handle several different types of credit simultaneously. In other words, they prefer to see several different types of credit utilized (credit cards, mortgage, installment loans, etc.)
Possible Action Items:
- Continue to pay all of your bills on time as this will increase your score in this area
New Credit (10%)
This section of your score will review several different items such as recent credit inquiries, new accounts opened, reestablishment of positive credit after past delinquent history, etc.
It has been said that a single inquiry on your credit (not including your own) can decrease your score by 5 to 35 points. Therefore, it’s crucial to limit the amount of inquiries on your credit (new credit cards, numerous loans, etc.).
Possible Action Items
- Limit the number of new accounts being opened (i.e. do not apply for every store credit card)
What’s NOT In Your Credit Score (And Why That Angers Me)
- Interest rates on credit
- Child support payments
- Credit counseling history
- Your race, religion, sex, marital status, etc.
- Where you live
- Your age
- Your salary
- Your employment history
- Your savings
So, as I mentioned before, I am not the biggest fan of the credit score, and the bold items (that are not included in your score) are why I don’t like it. Let me give you an example to show you why:
Let’s say that John Doe has had a credit card and a car loan since his 18th birthday. He is now 38 and decides to buy a house. He has used his credit card properly (paying it off each month) and has never missed a payment on his car loan. Therefore, he has an amazing credit score of 800+. He is currently employed and makes $75,000 per year (not bad) but has no savings to his name. However, since the bank is only reviewing his credit rating (they will also look at his income separately) they decide to loan him $200,000 at the best interest rate possible. Good for John!
Now let’s compare John Doe to Daniel Smith.
Daniel started his own business at the age of 18 and has paid for everything mostly in cash. He now wishes to buy a house at the age of 38. Since he never really utilized credit, he doesn’t have a much of a credit score (if he has one at all). His business nets over $250,000 per year, but he only takes a $75,000 salary and invests the rest back into the company. He also has substantial savings of $500,000+. However, since interest rates are so low, he wants to take out a mortgage so he can keep the cash and invest it for higher returns. After reviewing Daniel’s credit rating, the bank decides not to loan him the money because he cannot show that he can utilize credit properly.
That is why I dislike credit scores.
Credit scores only look at how you utilize credit. They do not take into account how much money that you earn or what type of savings you have. If I were a credit card company, I would prefer to loan money to the man who has $500,000 in cash and no credit score vs. the guy who makes $75,000 per year and has no savings.
But whatever, that’s just me.
I guess we’ll just keep worshiping the FICO score.
P.S. Please do not sign up for any of the services that the linked companies provide. If you are looking to obtain your credit report, the law allows you to receive three per year. Just head over to www.annualcreditreport.com.