Below is an excerpt from our Debt Free Forever Guide. Be sure to download the free guide to help dump debt for good.
There are a lot of myths out there about credit scoring –hopefully we can help you understand FICO scoring, so you can take action to build your score. There are five major components FICO uses to determine a credit score. Fortunately, understanding the secret sauce can help you build a strong score and healthy credit report. Both a 700+ score and healthy credit report will help keep the rest of your financial life cheaper by enabling you to get lower interest rates on loans and approved for top-tier financial products.
35%: Payment History
This is the single most important part of your credit score. Quite simply, this looks at how many on-time payments that you make. You will:
- Get rewarded for on-time payments
- Be punished for missed payments: Not all late payments are created equally. If you are fewer than 30 days late, your missed payment will likely not be reported to the bureau (although you still will be subject to late fees and potential risk-based re-pricing, which can be very expensive). Once you are 30 days late, you will be reported to the credit bureau. The longer you go without paying, the bigger the impact on your score, ie: 60 days late is worse than 30 days late. A single missed payment (of 30 days or more) can still have a big impact on your score. It can take anywhere from 60 to 110 points off your score.
If you don’t pay a medical bill or a cell phone bill, your account may be referred to a collection agency. Once it is with an agency, they can register that debt with the credit bureau, which can have a big negative impact on your score. Most negative information will stay on your credit bureau for 7 years. Positive information will stay on your credit bureau forever, so long as you keep the account open. If you close an account with positive information, then it will typically stay on your report for about 10 years, until that account completely disappears from your credit bureau and score. If you don’t use your credit card (and therefore no payment is due), your score will not improve. You have to use credit in order to get a good score.
However, there is a big myth that you have to borrow money and pay interest to get a good score. That is completely false! So long as you use your credit card (it can even be a small $1 charge) and then pay that statement balance in full, your score will benefit. You do not need to pay interest on a credit card to improve your score. Remember: your goal is to have as much positive information as possible, with very little negative information. That means you should be as focused on adding positive information to your credit report as you are at avoiding negative information.
30%: Amount Owed
This part of your credit score will look at how much debt you have. Your credit report uses your statement balance. So, even if you pay your credit card statement in full every month (never pay any interest), it would still show as debt on your credit report, because it uses your statement balance. This part of your score will look at a few elements:
- The total amount of debt that you owe across all of your accounts. On your credit cards, the utilization ?If you have a lot of credit card debt, your score can be hit.
- In addition to the total amount of debt that you have, your utilization is very important.
To calculate utilization, divide your statement balance (across all of your credit cards) by your available credit (across all of your credit cards). For example, if you have credit limits of $40,000 across 4 credit cards, and you have a total balance of $20,000 – then you have a utilization of 50%.
To have a good score, you will want your total utilization to be below 20%.
Why is utilization such an important concept? If you use every bit of credit made available to you, then it looks like you do not have self-restraint. Maxing out all of your credit cards is a big warning sign to lenders.
If you are able to restrain yourself and have a lot of available credit (that you do not use), then you are showing self-discipline.
It may sound strange (and, in fact, it is): but the key to having a good credit score is having a lot of available credit and not using it.
15%: Length of Credit History
This is the easiest part of the credit score to get right. So long as you don’t close accounts, every day this part of your score improves (because all of your accounts become one day older).
FICO will look at the age of your oldest account, as well as the average age of accounts.
10%: Types of Credit in Use
If you have experience with different types of credit (installment loans, revolving loans, credit cards, etc.) than you will get more points than if you don’t have a variety of experience.
The most important product is a credit card. If you have a credit card and manage it well, then you will be rewarded in this. Remember: there is no greater temptation than a credit card. If you are able to withstand the temptation of plastic, you get the most points.
10%: New Credit
If you open up a lot of new credit in a short period of time, you will be sending a warning signal to the credit bureau. But this part of the credit score has turned into a myth that scares a lot of people. They are afraid to shop for the best deals, because they are afraid of what shopping for credit would do to their credit scores.
The FICO score will look at credit inquiries from the last 12 months.
This factor is only 10% of your total score. And, there are a lot of myths. Lets break a few of them now:
- Checking my own credit report will hurt my score: FALSE! If you check your own credit report at www.annualcreditreport.com, it will not hurt your score
- If I shop around for a good mortgage or auto loan rate, my score will get crushed: FALSE! Multiple inquiries for a mortgage or auto loan are usually treated as a single inquiry.
- If I shop around for a balance transfer credit card, my score will get crushed: FALSE! If your score does decline, it probably will not decline by much. You can expect 10-20 points per credit application. But, remember: you apply for a balance transfer to help reduce your balance faster. When you open a new credit card and transfer your balance, then you will be able to:
- Have a lower overall utilization, because you have new credit available (and of course you will not use it!)
- Pay off your debt faster, because the interest rate is lower. At the end of 12 months, your score should be even higher than when you applied for the balance transfer or personal loan.
Quick Steps to Building and Keeping a Good Credit Score
- Use your credit card every month, but keep your utilization well below 20%. In other words, never charge more than 20% of your available credit. You can reduce your utilization by (a) paying down your debt and (b) increasing the credit that you have available
- Make your payments on time every month If you repeat these two things over time, you will eventually have a score above 700. However, if your score is below 700 and you want to improve it, you need to focus on:
- Putting more positive information into the credit bureau
- Getting your utilization below 20%
- Dealing with the negative information