Credit scores are like if your lenders posted Google Reviews about you and their experience lending you credit. It is a score that gives an idea of how responsible you are with credit, and if those who may lend you credit can trust you with it.
There are many resources out from the three major credit reporting agencies (TransUnion, Experian and Equifax) that outline the five major factors that influence your credit score, so I will leave those for you to find if you are not sure what they are. Each of these companies track their own separate credit score for you. You are allowed to get one free credit report (from each agency) each year, and due to COVID you are allowed a free report every WEEK until April 2022.
The purpose of this blog is to talk about some of the considerations around having a strong credit score, what it means, and how you can feel good about your score.
Biggest Impact to Score
The two major factors that impact your credit score are payment history and credit utilization, which are said to make up 65% of your credit score - if you nail these two items, then you are already on track to have a great credit score.
Payment history makes up 35% of your score and is just as it sounds - have you historically made your required payments on all your debts? This is a pretty easy one; if you are taking out credit, make sure that you are able to make the payments. It makes sense that one of the biggest factors that determine your credit score is telling the lenders if you have historically paid back the loans you have received - if not, they do not want to lend you money if there is a risk that they will never get it back.
The second major item is credit utilization which makes up 30% of your score. This factor is basically saying if the lender gives an $x credit limit, will the borrower use all that money? You will be seen as a riskier borrower if you are maxing out your credit card each month, even if you are consistently paying off the full balance.
This is largely related to credit cards - in other words, if you are approved for a $500k mortgage and decide to use all of that, this is not a credit utilization of 100%. This is considered “installment debt” which does not take into account the credit utilization like “revolving debt” does, which is typically a credit card.
The advice is to say under 30% of your credit limit, so if your limit is $10k, make sure to spend $3k or less each month on that credit card. Outside of making sure your spending is a responsible amount relative to your income, some other ways to stay under a 30% utilization rate include:
Spend less on your credit card, and more with cash or debit cards.
Pay off your balance mid-month to reset your spending - you can pay off balances at any time and do not need a month-end statement.
Request an increase in credit limit from your credit card company.
Open a new credit card (responsibly) and split expenses so you are using no more than 30% of the credit limit on each.
There are Different Types of Debt and They Should Not Be Feared
Debt should not be feared! As long as it is used responsibly and as a tool, having and using credit is important for your financial health.
When I say it should be used as a tool, I mean it is good to use debt if you are using it to advance yourself - like buying a car to increase your employment opportunities, buying a house to live or rent out, putting a medical procedure on credit to pay off overtime so you do not have to spend your entire emergency fund, etc.. You should be scared of taking out debt to buy those new shoes that you currently can’t afford because you “think” that you are going to get a raise next month.
As I previously alluded, having different types of debt (called credit mix) impacts your credit score in a positive way, because it shows you can responsibly manage different debts - if you are not responsible, then of course the different debts hurt your score. You shouldn’t seek to take out debt to increase your credit mix, just know that it isn’t seen as negative.
On the flip side, it may make sense to close some accounts if you are no longer using them to “clean up” your report and get rid of credit you no longer use. A couple considerations:
Make sure before closing, there are no fees or remaining balances on the line of credit.
If it has a strong and long history of responsible use, it may hurt your credit to close that account, as all that good history will be lost. It may make more sense to keep it open and use it rarely to make sure it stays open and that history stays.
Closing accounts may have a short-term negative effect on your credit, but this is typically pretty small and if you are not applying for credit in the short-term, then it should not take long to recover the drop.
What to Think About Your Credit Score
Your credit score is a long-term game - as I mentioned above, short-term fluctuations should not concern you as long as you are not applying for credit when it drops. If you maintain your good habits, you should be able to recover any short-term drops. If you are planning on applying for credit, it is probably wise to not close accounts or do anything to cause a short-term drop.
It is recommended that you occasionally check your report so you know your debts that are out there, confirming that all debts being reported are from you (and not fraud), and you are up to date with all your payments. It should not be obsessed over, but the score is free and you should keep on top of it at least annually.
One last point is to not stress over having the perfect score. Lenders typically work in ranges, and there is a maximum credit score they view as “excellent” credit. For example, many mortgage lenders consider you an excellent credit rating if you have a score of 720 or above. So, if you have a credit score of 800, which drops to 785 after closing a few accounts, who cares! You are still considered excellent and your rates will remain the same whether you borrow with a score of 800 or 785.
Common Misunderstandings & Final Thoughts
Your score is not impacted by things like income, assets or expenses – it is solely based on your use of credit. Lenders will also screen for things like your income and assets, but they do not get factored into your credit score.
As I mentioned above, your credit score is a long-term game and is a way to measure how responsible you have historically been with credit. Therefore, if you make one mistake, it is not forever ruined! You can prove it is just a blip or a mistake in an otherwise responsible history of using credit. Once you make a mistake, don’t chalk yourself up to being somebody with bad credit that can’t be fixed. Get back to your strong behaviors, and that blip will fall off over time.
I mentioned that it is good to check your credit at least annually – but if you need to check it more frequently, then that is okay too. Checking your credit is considered a “soft inquiry” and doesn’t have an impact on your score. If you are applying for credit like taking out a lot of cards or getting pre-approved by a few mortgage lenders, these are considered “hard inquiries” and will impact your score.
Just because you do not have excellent credit, this does not mean that credit is not available for you. If you really want something and need a loan for it, do not just assume that no one will give you a loan - but you will be seen as a “riskier” borrower. You can prove yourself by other means and try to work with the lender – some examples include showing a strong debt to income ratio, accepting a higher interest rate, or putting a bigger deposit down upfront.
Finally, a common misconception is thinking that every action by you has a known effect on your score. Each of the three reporting agencies have their own scoring, and each action may affect their scores differently. Just know it is not as easy as “if I close this account, how will that change my score?”. There may be many factors, so make sure you know you can take a short-term hit if you are deciding to make this change with your credit. It is also advisable to make changes a little at a time instead closing a lot of accounts all at once.
A credit score does not have to be scary – stay responsible, and make sure you are checking on it occasionally. A perfect credit score is not the goal, but knowing what yours is and developing behaviors to keep a strong score will only benefit you when it comes time to put that credit to use.