Credit Score, why do I need to know it? What is it? Does it really matter?
Find out how it all works ~
One of the major objectives in our cash flow review meeting is to completely understand the client’s cash flow picture. This means the income and outflow of cash to a household including number of accounts as well as expense tracking and purchasing mechanisms. Many times clients come in with LOTS of credit cards having found a specific use for each one.
A key part of the discussion is simplifying everything to the extent possible which often requires the closure of credit cards and/or opening new ones that better fit the client’s spending patterns and goals (think cash back vs travel rewards cards).
Clients are often concerned about the impact of these actions on their credit score as a result of misconceptions from old wives tales and the mainstream media so I put together the following to simplify the conversation.
The Five Factors of Your Fico Credit Score and Their Respective Weights
1. Payment History
The consistency with which you have made on time debt payments accounts for 35% of your credit score.
People are often hesitant to close a credit account because they fear they will immediately lose the benefit of the longevity of that account. Fear not. The payment history on a closed account does not disappear from your credit report when an account is closed.
While it would be nice if closing an account with a negative history removed it from your credit report that would circumvent the purpose of the credit rating process and is not the way it works.
The impact of history for closed credit is reduced over time which is why you typically hear that a bankruptcy only impacts credit for 7 years. Conversely, for good payment history, you will continue to reap the benefits of a closed account for 10 years.
By the time these good accounts fall off of your credit report in 10 years, you will likely have rebuilt enough of a credit history in the ensuing time to avoid a ding for lack of payment history.
2. Credit Utilization Rate
The % of the credit limit you have been granted that is currently being used accounts for 30% of your credit score.
Lenders looking to extend credit don’t like to see you using a lot of the credit that you already have. It makes you appear to be spread thin and people who need credit aren’t the ones lenders want to give it to (I know, go figure right?).
Most experts recommend not using more than 30% of the credit you have been granted.
This is sometimes where the “closing a credit account hurts your credit” misnomer becomes a reality. If you close an account that constitutes the majority of your credit limit, such that the credit you are using goes from 25% to 50% simply by reducing that available credit, you may find your score negatively impacted.
The obvious thing to do here is request a credit limit increase on the accounts you are keeping ensuring your regular utilization remains between 25% - 30%.
The question is often asked whether utilization is measured by account or the aggregate of all accounts. The answer is really both, so if you are deciding which card to request a credit limit increase on, make it the one you plan to use most heavily.
https://www.nerdwallet.com/ also has a great card finder feature where I typically send clients looking to identify the best card for their situation.
3. Length of Credit History
The longevity of your credit history is weighted at 15% of your score.
This is a measure of the time you have been granted any kind of credit. This is the one you most commonly hear as the impediment to young people attaining credit.
Obviously without someone taking the chance on you to start out, you cannot build a credit history. This becomes less of an issue the older you get because you will likely have accumulated a mortgage, car loans and credit cards as time goes on.
"When considering ‘length of credit history,’ the FICO scoring formula evaluates the ages of your oldest and newest accounts, along with the average age of all your accounts." New accounts will lower your average account age, which will have a larger effect on your FICO® Scores. Again this is primarily if you don’t have a lot of other credit history established.
Bottom line; this category is likely to have the most significant impact on younger people who are working on establishing credit as they increase their ability to borrow rather than for adults with long standing credit histories who are just opening a rewards credit card.
4. Variety in Types of Credit
Diversity in types of credit accounts for 10% of your credit score.
This is diversity of your credit specifically how many different kinds of credit you have (auto, home mortgage, credit cards).
More is better (within reason).
5. New Credit
Recently opened credit accounts for 10% of your credit score.
Apparently research shows that opening several new credit accounts in a short period of time represents greater risk - especially for people who don't have a long credit history. I guess this makes sense right? If someone with a steady payment history suddenly significantly expands the amount of credit available, they have just increased their potential risk to a creditor until they are proven responsible with their significantly expanded credit. However, they only weight this category at 10% of the score so it is a minor factor.
The common misnomer here is that “credit inquires will significantly lower your credit score.”
It is true a “hard inquiry” for new credit like a new credit card may ding your credit score a few points, but this category only makes up 10% of your credit score and new inquiries are only taken into account for a year, so the impact of a new inquiry is minimal and temporary.
Likewise a “soft inquiry” or when a non-commercial entity checks your credit, like you would with one of the now popular services, there rarely is any impact on your score.
Multiple inquires for the same item like rate shopping for a car loan are often seen as a single inquiry.
In short, because it is such a common concern, here’s what is worth noting regarding credit inquiries:
The whole category is only 10% of your score
Inquiries usually have a small impact
Many types of inquiries are ignored completely
The score allows for "rate shopping" so multiple inquiries for say a mortgage count as only one
Inquiries remain on your credit report for two years, although FICO® Scores only consider inquiries from the last 12 months
If you take one thing from this article remember paying your bills on time and not using too much of your available credit account for nearly 2/3 of your credit score. These are the ones to focus on.
Make sure that you make all of your payments on time. This includes making the payment process as simple as possible. Keeping just one or two cards rather than a card for every store that you shop at will make this a snap.
On the cards that you keep, make sure you have at least 3Xs what you will use at any time on a given card in credit limit to make sure you are not penalized for using too much.
Perhaps most importantly, a credit score of about 740 is typically going to get you the best rates available on a mortgage or car loan. With a rating scale to 850, you don’t have to be perfect. While it is possible to have a credit score into the 800s, what it takes to have a score that high has no real payoff.
Here are a couple of more articles from Bankrate that I found valuable on the topic: