Credit scores determine almost every major financial decision in our lives and it is our credit cards that have some of the biggest impacts when used improperly. Credit card debt is ranked among the highest, not too far behind mortgages and student loans.
If more people understood how credit scores are determined – perhaps less people would make irresponsible decisions with them. I used to be one of these irresponsible people. I’ve personally had a collective amount $80,000 in credit card debt over the span of the last 12 years of my life. I would run the cards up, pay them off and run them right back up again. Eventually, it caught up to me, a switch in my career prevented me from being able to pay them off as far and before I knew it I had reached my personal highest balance at one time ever, roughly $35,000 in credit card debt (as I spoke about in my post Eliminate Debt & Welcome Opportunity). My credit score was at a 630 and I was spending every cent I had on minimum payments. I went from making $130k a year to $70k a year. After taxes it’s amazing how little $70k a year really is…
By educating myself and making better decisions I was fortunate enough to be able to turn this around in 1 year. I was able to make a switch in careers again for higher pay. I understand others may not have the same opportunity as myself but that is no reason to dismiss what I am going to share. Understanding how your credit score is comprised will drastically change your life financially.
You can find this exact chart on myfico.com. I use this chart because FICO is the score you should be most concerned about. Almost every time your credit is checked for a mortgage, car loan, or some other big loan your FICO is what is looked at.
As you can see, there are 5 categories that make up a complete credit score. Each category “weighs” as I like to say, differently on your credit score. I will begin by explaining each of these categories:
Amounts Owed weighs the second most on your score accounting for 30% of it. This is also known as “Credit Utilization.” This is the ratio of your balances to available credit for ALL of your cards together as well as your the ratio of balance to credit limit for your cards individually; this is a double whammy. Do NOT mistake available credit for their individual credit limits.
if you have 1 credit card with a credit limit of $10,000 but you have an outstanding balance of $5,000; your available credit is $5,000 and your credit utilization is 50%. Let’s say you open a second card and receive a $5,000 credit limit on that card and you exercise some discipline and don’t run your balance up (this can actually be a strategic way to lower your credit utilization and you’ll see why). Your new available credit is a total of $15,000 but you still only have 1 outstanding balance of $5,000. You’re credit utilization in all went from 50% to 33% because the outstanding balance remained the same but your total available credit went up.
The utilization will remain 50% for the 1 card and if you pay it down below 30% of your credit limit you’re score will see serious benefits. 30% of 10,000 is $3,000 and $3,000 is 20% of $15,000; see how that works?
But what about credit inquiries? I’m glad you asked!
New Credit is exactly that. The amount of credit inquiries you have is responsible for 10% of your credit score. So in the previous example you opened a new card to strategically lower your utilization. Even though you took a “hit” on your credit to open the new card, it only accounts for 10% of your score – so the points you gain from lowering your credit utilization will outweigh the points you lost for the new account (30% versus 10% the difference of 20% wins). Credit inquiries fall off your credit report after 24 months and the effects of an inquiry only last about a year (although I tend to disagree with this).
Length of Credit History
Length of Credit History accounts for 15% of your score and is pretty self explanatory. This can be used strategically to boost your score (this is something I actually did and helped a couple of friends do). You’re length of credit history is actually an average age of all your accounts. So let’s say you have a credit card that you’ve had for 10 years but a new one for 1 year.
You’re average age will be significantly impacted and will overall lower your score slightly. You will often hear people telling others “don’t close your credit card let the bank close it for you from being inactive because you’ll take a hit on your credit.” This is only partially true.
I had lowered my credit utilization to 0% but I had some new cards that I opened to take advantage of 0% interest balance transfers so I could make minimum payments while saving money to make bigger payments and not pay interest in the mix. My average age of credit suffered because of the new accounts – so I closed them. I lost some points because of the inquiries that still remained from opening the accounts but I gained more points towards my credit score because my average age of credit history went up.
Here is where this gets dicey and this is EXTREMELY important. This worked for me because my credit utilization was 0%. If you were to do this with balances on your cards you’d be increasing your credit utilization because you’d be decreasing your available credit. Let’s go back to our other example. You had a 50% credit utilization on your $10,000 card because of your $5,000 balance.
You open a new card (without transferring the balance because you didn’t know any better) and continue making minimum payments leaving the $5,000 on the $10,000 card and now have a total utilization of 33%. You pay off $2,000 of your $5,000 balance bringing your balance down to $3,000 out of $10,000 for a credit utilization of 30% on the individual card but an overall utilization of 20% because of your $15,000 available credit.
Now you close that $5,000 card because you’re trying to be slick and increase your average age of credit history. If you close that card, you just lowered your available credit to $10,000 with a $3,000 balance. Because this is your only card, your utilization went back up to 30% because your total available credit is now your credit limit and utilization is responsible for 35% of your credit score; this will hurt.
Let’s say you opened a balance transfer card and transferred the balance of $5,000 to take advantage of 0% interest while you save some money and make minimum payments to make one bigger payment later. If you transferred $5,000 to that card this cards utilization just went to 100%. You now have 100% utilization on one card but 0% on the other, you’re overall utilization will still be 33% of your available credit. Because that one card is 100% it will look worse to lenders so be sure to pay it down as fast as possible (this happened to me).
Credit Mix is better explained as “types of credit.” Basically, how many different types do you have and how many of each type do you have? Having 3 credit cards is okay but I wouldn’t recommend more than that because they can make you look risky (DO NOT OPEN CONSUMER CREDIT CARD ACCOUNTS I DON’T CARE WHAT THEY OFFER YOU!). Consumer credit cards are the ones you open at the store when checking out to save a percentage off your purchase.
Lenders view this as impulsive and they will view you as high risk because of that, thus, you’re interest rates for things such as auto loans, mortgages will be higher. Auto loans, mortgages and student loans are actually considered “good credit” to have because they help contribute to your average age of credit history since they are longer accounts and they help establish payment history which overall makes you look responsible (as long as you don’t miss payments). You can see why it would be good to have different types of available credit. Credit Karma actually does a good job with these numbers. They will tell you how many credit cards are acceptable, and how many accounts in all is good for your score too.
Lastly, but certainly NOT the least, weighing in at 35% of your score, is payment history. Missed or late payments stay on your credit report for 7 years although the points lost on your score because of them will come back sooner than that. Perfect payment history is crucial I cannot stress this enough and this is all the more reason to be very cautious about co-signing for someone… 3 stories about this. Myself first. I was on a semester at sea and a payment didn’t go through on time. The late payment was reported. This was almost 7 years ago, August of 2014. When I took out my mortgage this one time late payment showed up on my credit report even though my credit score was currently an 800. They wanted to know about it. Luckily it didn’t have an effect on my mortgage at all but this could have created serious problems.
2nd Story. My mother let my father take out a home equity line of credit on her house (they are divorced and she finished paying off the mortgage). She had to sign the HELOC because she and my father both owned the house. My father forgot to make a payment one time. My mothers credit score dropped 65 points and even though the late payment wasn’t her fault and had NOTHING to do with her, it still effected her score. She wanted to take out a new mortgage to buy my father out and a few banks denied her because of my fathers missed payment.
3rd story, one of my friends who I am currently helping fix his credit score and helping straighten out his finances co signed a loan for his father. HIs father missed a payment and now my buddy is stuck with this on his credit report, his score suffered, and now won’t break past a 740 until enough payments are made on time to offset that late payment.
Side note: as we all know student loan payments were postponed until September of this year (2021). I was stoked to not have to pay interest or make payments in the mean time. This was a bad idea (luckily because I automated all of my finances I’ve been putting that money aside anyway and have it as explained in my post Automate Your Finances to Secure Your Future). This was no good because if you stopped making payments you will fall behind schedule and this will have an effect on your credit score. Basically, X amount is supposed to be paid off by Y time because Z amount of payments were supposed to be made. Since I stopped making payments and NOBODY SPOKE ABOUT THIS REASON TO KEEP MAKING THEM, my loan balance was higher than it should have been had I kept making those payments. Now, when payments resume my monthly student loan payments will go from $232 to just shy of $400 a month to make up for that lost time. This is basically a “balloon payment.” Since I have the money in my bills account I can make a years worth of payments and get right back on track and not have to worry about these balloon payments and set set aside more money.
Come on… Give me some credit!
You may have to read this article a couple of times because there is a lot of information in here but I promise you this information will help you fix your score! I was inspired to write this because, very much like my research for mortgages (see my post Homebuyers Guide to the Galaxy) I couldn’t find a good one stop shop that explained the ins and outs of credit factors. By understanding these factors you can really sit down and strategically plan to fix your credit score. It’s like a game of chess. You just have to move the pieces around and figure out which way works best for you.
As always if you have any questions about anything I mentioned feel free to drop them in the comments below and I’ll explain.
If you want help fixing your credit privately I would be more than happy to do so and am available for hire.