Are you planning to get a home or car? The next thing that comes to mind is how to finance? Comprehend the motive of banks, they are in the lending business to make profit, so naturally they would want to lend their money to trustworthy people. Are you looking to rent a spacious home? Most landlords will ask to check credit score before they let you rent to check your history of payments and make sure you are trustworthy.
How is Credit Trustworthiness measured?
Credit trustworthiness is measured by a score called Credit Score. Credit score range tells you if you are at all level where the bank or landlord trusts you enough that they can offer you lower rates. If your credit score is not good enough, they will tack a premium on your rates to make sure they are still taking a risk worth its reward. Your interest payment is their revenue and they want to maximize it and avoid non performing loans.
What is Credit Score?
Credit scores are analyzed by taking bits and pieces of information from your credit reports and forecasting that data to project your likeliness to pay back the debt. They determine how responsible you are by checking your recently opened accounts, history of payments in time and credit utilization ratio from currently open lines of credit.
It can be an intimidating process to build your credit for the first time. However, you can construct your credit score quickly to move to a good enough range. We need to fully understand the parts that contribute towards the final credit score and how much it contributes.
Who Creates Credit Scores?
FICO or VantageScore have their scoring models that potential lenders can use to determine likelihood of getting payments back. FICO is heavily used in the banking and credit card industry while Vantage score is recently catching up with its use. These models use credit information from the major credit reporting agencies in the US – Experian, Equifax and TransUnion.
What is a Good Credit Score?
Each lender decides how to use these numbers and follow their own risk profile.
According to Experian, a score over 800 is considered exceptional. A score between 740 – 799 is rated very good, 670 – 739 is good, 580 – 669 is fair, and 300 – 579 is very poor.
How Is Credit Score Calculated?
Credit reports, which tracks the health of your financial life, reflects the credit score. Generally, there are two different scores available. They are FICO score and Vantage Score. Additionally, there are multiple models within each of these scores and models keep evolving over time.
Credit Score determination will take five inputs
- History of Payments – It checks if you have paid all your past bills on time. If you have a habit of carrying balance and paying late, this will reflect your habit and bring your score down
- Mix of Credit – Lenders want to see you are responsible with multiple lines and mix of credit. The more mix of credit you have, the better it is.
- Utilization of Credit – The amount of credit that you have spent so far as a ratio of total limit of credit balance you have. Remember, you need to keep this under 30% if you are looking for a good score.
- New inquiries – Don’t keep applying new credit cards. This will tell lenders that you are a high risk customer. Space out your new credit card applications.
- Average Account Age – Don’t close your old accounts, it will affect your AAOA. The older average time you have on your report, the better.
What Is The Timeframe To Construct Your Credit?
It initially takes 6 months to calculate our first credit score. Credit Reporting agencies wants to see some steady activity, before they start providing a credit score. Timely payment and not opening too many new accounts in the beginning of your credit journey will help you.
Similar to get rich quick schemes, you can build your credit score fast, but there are downsides. You need to take a lot of different type of loans and make timely payments on each of them. Do not keep this as your main goal and let your credit score raise slowly over time. There is no get rich quick scheme, similarly, there is no get credit score up quick scheme in easy way.
What Is Credit Score Made Up Of?
Alright, now you know a lot about Credit Score. So what is your credit score? I am going to reiterate that there are different variations of credit scores. One being FICO score and the other being Vantage score. Within them, you have atleast 10 different models each.
Lenders will have their own preference of a scoring model and go with it while hard pulling your credit. All models use the same of 300 to 850, just that the score differs slightly in each model. Although, FICO is heavily used, there have been recent increase in usage of Vantagescore.
We already know the five inputs to FICO model that makes up the credit score. But, let’s check the weights attached to each event.
- History of Payments – The history of past payments is the most significant with 35% weight. You miss one payment and your will credit score will at least suffer for a few years.
- Credit Utilization Ratio – Uitilization of Credit takes up 30% weight. Don’t send red flag to lenders with a high CUR. My personal recommendation is to keep it within 10% and aggressive recommendation is to keep it at 1%.
- Average Account Age – Average Age of Accounts is an important factor that takes up 15% weight. Keep your old accounts forever to have AAOA high and give confidence to lenders.
- Credit mix: 10% weight. Having different types of credit will help increase the score. I just have the credit card revolving debt on my account, so I need to improve on this front.
- New Credit Hard Pulls: 10% weight. As and when you put in an application for a new credit card, a hard pull lands on your report. It instantly lowers credit score for some months before it comes back up to the same point. Space out your applications and avoid damage. Also, remember getting new credit brings down your Average Age of Accounts.
Are Credit Cards The Only Way To Build Your Credit Score?
Credit cards are just only one part of how you can build your credit. There are other varieties of credit accounts out there, including personal loans, auto loans, student loans and mortgages. These can either be revolving credit or installment credit. Improve your credit mix by combining one each of everything, if you can.
What Happens When You Close A Credit Account?
- The output of factual information present in your credit report reflects the credit score
- Alterations to one of the five inputs in the report may change credit score to various extents.
Closing an old account
- reduces the # of revolving accounts that is currently open
- brings down the total credit limit abruptly
- may result in a lofty credit utilization rate
- Average age of accounts may take a hit, especially if it is one of the older accounts
You see, closing your card affects multiple things on the report. I cannot tell you exactly how much your score will go down if you close a particular card. The models are so complex with multiple combination of factors that no one can estimate except the Credit Rating Agencies.
Some Common Scenarios with Credit Score Change
Credit scoring is a complex path with crazy data science models running on your history of data but let’s break it down with simple scenarios.
Here are the last few tips that you need to know in order to get the complete picture
- You need to honor your agreement to pay back debt on time all the time. If you don’t do, your credit score may have a negative impact. The general consensus is not to carry any balance in credit cards (We are not random money blog, our audience aims to FIRE soon and I assume we’re already good with money management).
- Try not to have outstanding balance beyond the last due date. Contrary to popular thinking or myth, outstanding balances are not needed. Pay your bills in full always and be on the good books of credit reporting agencies. 0% credit utilization rate is ok but it is generally good to keep at least 1% of the credit limit and pay them before due date.
- Any adverse info on your credit report can bring down credit score. If you just miss payment for the first time, maybe some card issuers will be ok to work with you and not report it. But, if you miss again, there is a record of late payment and it stays your credit report for 7 years. Needless to say, it will be difficult to rebuild credit. If you declare bankruptcy and think you can escape from payments, it will stay for 7-10 years on your credit report.
- One positive thing is getting a negative information on your report is not the end of life. It will eventually leave your credit report. If you encounter a mistake done by Credit Reporting Agencies, then report it immediately. Your credit will be restored when they fix the information.
How can you monitor your credit
I don’t personally like spending my hard earned money on a subscription for Credit monitoring. I use the free monitoring service at Credit Karma for Transunion and Equifax VantageScore 3.0 and track my Experian free through their mobile app. If you are curious to know how, comment on the blog and I’ll send you.
It is best that you regularly monitor your personal credit and identify errors early. Correcting mistakes in credit report is not a straightforward. But, the credit reporting agencies will work with you to correct any verifiable errors on your report.
In conclusion, you will reap benefits of low interest rate or/and higher trustworthiness. Rather than settling for a good enough credit score, it is always better to improve your score even more and get your credit score to 800.