How To Read & Understand Your Credit Score

Credit scores are the numbers used by lenders to help them decide if they want to lend to you. The higher your credit score, the more likely you get approved for and the more likely you are to get a better rate on any loans. Your personal credit score is based on your credit history and is meant to represent the likelihood you repay your loan.

Credit scores are important as they can cost or save you real money. Additionally, the higher your score, the more opportunities you are given to open top-tier rewards credit cards

Credit scores are a single number between 300 to 850 and are calculated on 5 factors. They attempt to create a single numerical view of your riskiness to simplify the lending decision of lenders.

In short, understanding, monitoring, and caring for your score can have a real world impact on your personal finances.

What Is A Credit Score?

Your credit score is a single number that lenders use to make lending decisions on you. The higher the score, the better risk you are perceived as. Credit scores are your ticket to getting approved for loans and getting lenders best rates on the loans.

Most credit scores range from 300 to 850 with 850 being ‘perfect’ credit. The higher your score, the better risk you are viewed as. In general, credit score ranges fall into the following categories:

• Exceptional Credit: 800 to 850
• Very Good Credit: 740 to 799
• Good Credit: 670 to 739
• Fair Credit: 580 to 669
• Poor Credit: 300 to 579

Exceptional credit means you are well above the national average and will likely get approved and the best offers a lender has.

Good and Very Good credit means you are at or above the national average. You are a good borrow and will likely get approved, but may not qualify for the best offers or lowest rates.

Fair credit score puts you below the national average and you start running the risk of being denied on any applications.

Poor credit means you are well before the national average and are deemed a risky borrower. You are likely to be denied on anything but the most entry level of products. Additionally you likely pay very higher rates on any loans.

However, having little to no credit & credit history can be seen as even worse than fair or poor credit. Since your riskiness is unknown, many lenders are hesitant to lend to you. This is a catch-22 where you need to get credit history, but in order to get credit history lenders want to see your likelihood of payment.

But don’t worry if you don’t have good or exceptional credit, we will discuss tricks to improve your credit later.

Who Calculates Your Credit Score?

The most important entities for your credit score are the 3 major national credit bureaus: Experian, Equifax, and TransUnion. All three bureaus us the Fair Isaac Corporation (FICO) credit score model.

There will be some difference in your score between the 3 bureaus as some companies don’t report to some bureaus. However, the scores should be fairly closely aligned.

There are many smaller bureaus but the 3 major ones are by far the most widely used.

Additionally, the VantageScore is a smaller, but growing, consumer credit rating system. FICO is still used in the vast majority of credit decisions, but VantageScore is starting to be more widespread. VantageScore was developed by the 3 major bureaus and uses artificial intelligence (AI) to determine your creditworthiness.

For now, focusing on FICO credit score will be the biggest bang for you effort.

What Factors Make Up Your Credit Score?

Your credit score is weighted based on 5 different factors. Each factor has a different weight based on the importance. The 5 credit score factors are:

• 35% Payment History
• 30% Credit Card Utilization
• 15% Average Credit Age & Established Credit History
• 10% Credit Mix & Number of Accounts in Use
• 10% Number and recency of hard credit Inquiries

1) Payment History (35%)

Your payment history is the most important factor in your credit score as it shows your ability to make on time payments. Since your lender’s biggest concern is getting the loan paid back, you want to show you are reliable. Your payment history is the factor with the largest weighting so paying on time is the best way to get a higher score.

If you have multiple missed payments, they can result in a ‘negative record’ or ‘derogatory mark’ on you credit report. Late payments are bucketed into 30, 60, and 90+ day delinquency buckets. Once a late payment is 90 days delinquent, credit scoring models view you as having a high chance of missing payments again.

In short, pay your bills every time and on time to have the biggest positive impact on your score. Using automated bill payments and having online alerts are a way to track and pay your bills. This can dramatically help remove the risk of a missed payment.

However, make sure you aren’t overdrawing your bank accounts and incurring fees.

2) Credit Utilization (30%)

Your credit utilization is a ratio of the debt you have to your total available credit. Utilization is also referred to as a debt-to-limit ratio. Having a utilization rate that is below 30% is seen as acceptable, but the lower your utilization the better.

Having a high credit utilization can be seen as you being overextended. If a lender thinks you are using too much of your credit, they may view it as you being unable to handle all your debt.

Since your utilization is a ratio taken across all your cards, you can improve the rate by both decreasing your credit balances and increasing your available credit.

You should not be carrying credit card balances month-to-month since the interest on them are high. Therefore, for everyone else, increasing your available credit is likely the best way to decrease your utilization rate. There are 2 quick ways to increase your available credit. You can open new cards, but opening a card leads to a hard inquiry which has a short-term negative impact on your score (see below). Or you can request an increase in your credit limit from cards you currently own, which doesn’t have any negative impact.

Credit utilization is the second most impactful factor on your credit score. Therefore, increasing your available credit can be a quick way to have a material positive impact to your score.

3) Credit Age & Established Credit History (15%)

Having a long credit history is a positive to your credit score. Lenders like to see a long history of consistent on-time payments across all of your accounts.

This factor includes the average age across all of your accounts, how long since you used each account, and the oldest & youngest aged account on your profile.

To improve your credit score, you want to keep older accounts open and active. A common piece of advice is to put at least one small, single, re-occurring expense on your old cards. This will improve your oldest aged account and increase the average age. Closing old accounts will not only hurt your credit age, but decrease your available credit and hurt your credit utilization rate.

4) Credit Mix and Account Usage (10%)

The mix of your credit and the number of accounts you have open has a smaller weighting on your overall score. In general, the more diverse and the higher quantity of accounts you have, the better on your score.

Credit scores take a look across credit cards, mortgages, student loans, auto loans, and any other lines of credit.

When a new lender sees you have numerous accounts, they know you have been approved by many other lenders. This makes them more likely to view you as a good borrower.

Additionally, diversifying across the main 2 credit categories shows you aren’t overly concentrated in one type of debt. The 2 main categories of credit are revolving credit and installment loans.

• Revolving Credit: credit products where you make different payments based on how much you spend each month. For example, products like credit cards and home equity lines of credit (HELOC).
• Installment Loans: credit products where you make a fixed monthly principal payment over a pre-determined timeline. For example, products like student loans, mortgages, and auto loans. Variable rate products also fall into this category as the interest component changes but the principal paid follows a schedule.

However, you should not open an auto loan for the sole purpose of diversifying your credit category. The impact of credit mix overall is smaller than the other categories and having a lower outstanding debt balance will have an overall positive impact.

5) New Credit & Hard Credit Inquiries (10%)

There is a short-term negative impact to your credit score when opening up new lines of credit. Each time someone pulls your credit report, it is considered a hard credit inquiry. Inquiries can be from a lender (credit card or loan), a landlord as part of background check, or an insurer as part of underwriting. However, not all credit inquiries are treated equally.

There are two types of credit inquiries you should be aware of, hard and soft inquiries.

• Hard Inquiry: Hard inquiries are reflected on your credit score and are visible to anyone who accesses your credit report. These typically are only done after getting your permission. Hard inquires occur when a financial institution accesses your credit report after you apply for new credit.
• Soft Inquiry: Soft inquiries do not impact your credit score and are only visible to you when you access your credit report. These occur when landlords, employers, or even your own self accesses a copy of your credit report. When you are getting a pre-approval offer or rate quote, these will typically be soft inquries

A hard inquiry can stay on your credit report for up to 2 years. Although, a single hard inquiry shouldn’t impact your score more than a few points.

However, seeing many hard inquiries in a short time frame may be detrimental to your score. Lenders may view this as you applying to many places due to being unable to qualify or being desperate for money.

If you are infrequently opening accounts as part of your regular financial living, the occasional hard inquiry is not a major concern. Do note, new credit impacts both this factor and lowers your credit age, albeit it can help with your credit utilization rate and credit mix.

Where Do You Find Your Credit Score?

There are a handful of ways you can find and monitor your credit score. First, many credit cards offer free credit score monitoring as a service. They will show you a FICO credit score right on the user interface when you log-in. This is an easy way to see your progress with no extra work.

Secondly, there are sites who will give you free credit scores. Credit Karma is one of the most well-known, but there are many similar ones out there. When you log into your profile, you can see a more detailed breakdown of your credit score. They will highlight which of the 5 factors are low and that can help you figure out how to improve your score.

Third, you can get a FREE full credit report each year per federal law. This is a full detailed credit report that covers all the items lenders get during a hard inquiry (with some extra soft inquiry items). This credit report will have the most details.

Note – all these credit score numbers are a point-in-time snapshot and will include things like any unpaid credit card balances even if they are not due yet.

How To Improve Your Credit Score

You now have enough information about how your credit score is calculated to take steps and improve your score. Here are 5 easy tips for improving your credit score:

1. Always make on-time payments: Even if you can’t pay the entire amount, making at least the minimum payment is better than nothing. If you find yourself constantly falling behind your payments, you need improve your budgeting. To help make payments on time, set up calendar reminders, sign-up for email reminders, and/or enroll in automatic payments
2. Optimize your credit utilization: Having a credit utilization below 30% has a large positive impact on your credit score. You can achieve this by putting small amounts on your credit card OR by having a lot of available credit. If you don’t want a lot of credit cards, you can ask for a credit limit increase on cards you own.
3. Keep Old Cards Open & Active: To retain a high credit age and long established credit history, keep your older cards open and put a re-occurring charge on them. By being thoughtful about closing accounts, you can improve your score.
4. Check Your Score Regularly: Between free credit scores on many credit cards and free credit services you can monitor any adverse changes to your score. Once a year you can get your full credit report for free as well. By monitoring your score, you can quickly see any decreases and ensure you someone is opening lines of credit in your name.
5. Spread Out Hard Inquiries: Too many hard inquiries in a short period of time can negatively impact your score. If you try to spread out any new accounts, you can avoid most of the negative impact from opening new lines of credit.

As a bonus, one of the easiest ways to build a more robust credit score is through opening credit cards. After a small initial decrease to credit age and hard inquiries, you get the benefit of a better utilization ratio and growing credit age.

[Professor B.T. Effer Note – Many credit cards give promotional bonuses when you open a new card and spend a low amount. A few hundred dollars a year for opening a new account is a nice perk as well.]

The Final Word – Understanding Your Credit Score

Credit scores seem like a complicated black box. However, if you follow the steps above, you can increase your credit score.

If you are just starting to learn about your score and improve it, you should sign-up for Credit Karma, or one of its competitors, so you can get a basic breakdown of each of the 5 factors that go into your score.

Then you just need to be mindful about how to improve the factor you are lacking in.

When you have a high credit score, you can get the best offerings from companies and it can save you significant money over your lifetime.