Understanding Your Credit Score (and How to Increase It)
Over the years I’ve noticed that many people use their credit scores as a proxy for their financial health. It’s something tangible that we can see go up or down and the higher it is, the easier it is to get a new credit card, take out a mortgage, and even get a new job.
With something as nebulous as our finances, it can be really nice to have a report card. People actually ask me all the time: “if I were to have a grade in my finances, what would it be?” We want to know if we are getting an ‘A’ in our personal finances or just squeaking by.
It’s natural to want to compare ourselves with others. Our financial satisfaction is often determined by who we spend our time with. If I’m a multi-millionaire that hangs out with billionaires, I’m more likely to feel dissatisfied than if I hang out with other multi-millionaires.
Unfortunately (or fortunately), no such quick grade exists to evaluate how we’re doing financially. We all have different goals, values, and timelines - and we’re all starting from different places. It’s something we have to evaluate for ourselves and check in on over time.
So if credit scores are not a barometer for our financial success, what are they and why should we care about them?
But what is a credit score, really?
Our credit score is a number that is used (usually by lenders) to determine how likely we are to repay our debt. The most commonly used credit scoring models are FICO and VantageScore (created by the three major credit bureaus: Equifax, Experian and TransUnion) and both range from 300-850. The higher the better.
Every time a lender evaluates us for a credit card, mortgage, or car loan, they use their own factors, often including one of both of these scores, to determine if they want to lend to us and how likely we are to pay them back.
The information that determines our credit scores comes from our credit reports, which are supplied by the three major credit bureaus. You can pull a free credit report from each bureau annually at annualcreditreport.com. Some people like to put them all at the same time and read them all over. Some like to pull one every four months as a way to self-monitor their credit year-round.
Who else cares about my credit score?
In addition to creditors and lenders, current or prospective employers, potential landlords, utility companies, insurance companies, and debt collectors may all want to check your credit score.
Will checking my credit hurt my score?
This is a very common misconception, but I understand why it happens. We can check our own credit scores as much as we want. Yay! When someone else - such as a lender - checks our credit score, they can do it in the form of “soft” or “hard” inquiry. A soft inquiry does not affect our score. When we receive credit card offers in the mail, they’ve done a soft inquiry. Companies can do soft inquiries into our credit without our permission.
Hard inquiries will ‘ding’ our credit score a few points and stay on our credit report for a few years. We have to authorize any company before they are able to make a hard inquiry into our credit, which is important when we are weighing different lenders. As we do our research, we do not want them making hard inquiries into our credit as it may affect the interest rate or whether or not we are able to get the loan if we were to choose a different lender.
What makes up our credit score.
The FICO and VantageScores are very complimentary, meaning if you have a high score in one, you’re more likely to have a high score in the other. However, there are some key differences to consider.
FICO
Let’s start with FICO. Here’s what makes up your FICO score and each factors’ relative importance:
Payment history: 35%
Have you paid your past credits on time? The single biggest factor in both of our scores is whether or not we’ve made on-time payments. If we keep all of our loans in good standing (i.e. nothing more than 30 days late), we will keep this section in good shape.
Amounts owed: 30%
This looks at how much of your credit you are using. For example, if you have credit limits on your cards that total $10,000 and you are using $9,900 of them, you are utilizing most of your credit. This can signal that you are potentially “over-extended” and therefore at a higher risk of not paying back your debt.
You might think that paying off your credit cards in full each month will keep you a 0% utilization, but this is not the caseYour utilization is calculated at whatever point the credit bureaus check your information. If they happen to check when your balances are at their peak and your credit utilization is the highest, that’s the number that will be factored into your current credit score.
Keeping your balances low throughout the month is a trick to keep your utilization low. Some like to continue to raise their credit limits to make this ratio better and better, but if that causes you to spend any more money, it’s definitely not worth it. For many us, higher credit limits puts us in more danger of accumulating more debt.
Length of credit history: 15%
This is determined by how long you’ve had credit. What’s the oldest credit card you have? People with very little credit history can still have high scores (since this only makes up 15%) but over time, as we build our track record, this area will work in our benefit. This is one of the areas that will just take time.
New credit: 10%
If we’re opening up a bunch of new credit cards at the same time or taking out multiple loans, this is a signal that we may become over-extended. To keep this area in good standing, we don’t want to open up multiple credit cards at the same time, if possible.
Credit mix: 10%
FICO considers our mix of different types of accounts like credit cards, mortgages, and retail loans to get more data on how we interact with our debt.
VantageScore
Here’s what influences your VantageScore and each factors’ relative importance:
Total credit usage, balance, and available credit: extremely influential
This is like the FICO credit utilization above. VantageScore recommends keeping balances low, below 30% of your limits at all times.
Credit mix and experience: highly influential
This is talking to our credit mix over time. It’s helpful to have a variety of accounts over time like credit cards, auto loans, mortgages, etc. to improve our scores.
Payment history: moderately influential
This one comes in as less influential for VantageScore than for FICO (where it’s #1). Making on time payments will keep this area in good standing.
Age of credit history: less influential
The longer accounts are in good standing, over time, the better this area of our score gets. This area gets impacted when we close our oldest accounts.
New accounts: less influential
This is the least influential factor for our VantageScores, but it’s affected by opening multiple accounts at one time.
Is our credit score a proxy for our financial health?
The short answer? Not really. Our credit score mostly shows that we’ve had credit (debt or the ability to take out debt) and what our payment history looks like. A high credit score also shows that we aren’t maxed out and that we have room on our credit cards. Those in the highest credit score ranges have lots of room. They also haven’t opened up a bunch of new credit cards at the same time.
Why does it matter?
If you plan on taking out any type of debt, a higher credit score can mean a much lower interest rate. Depending on the size of the loan, that can mean hundreds and thousands of dollars saved over the life of a loan.
If your credit score isn’t where you want it, that’s okay. It can take time to build up your score, but you can proactively address the areas the areas mentioned to improve your score while you wait.
