When I explain how credit scores are calculated to people, I find myself using an analogy to the Wizard of Oz. Credit scores are determined by the bureaus using a method that we are never privy to and that no one really ever tells us. The credit bureaus remind me of the Wizard of Oz, plotting and making things happen behind a screen and curtain. We will never know the weight given to any of the below categories or how the categories are compared. But, if we understand what goes into calculating our credit score and improving those items, we can begin to pull back the curtain.
Analogies aside, here are the seven main items that determine your credit score:
- Timely Payments – This item is straightforward. Your credit score is calculated based on whether you make timely payments or not. A one month late payment reported to your credit bureaus can stay on your credit report for years. If you make a late (30 days late or more) to Macy’s, it could negatively affect your credit for up to seven (7) years! Takeaway tip: Make sure you only use as much credit as you can make the payments for each month.
- Latest activity – Part of your credit score also depends on your recent credit inquiries. Every time you go to open a new credit card, buy a car, or even some employment screenings, there is a mark on your credit report. It can affect your credit score in both good and bad ways. The credit inquires can affect your credit score in a good way because applying for credit (and being approved for it) will help with diversity of accounts and available credit. The credit inquires can also affect your credit score in a bad way if you are declined for credit or if you do not have credit inquiries in the last 2-3 years. Failure to seek new credit can also affect your credit score. Takeaway tip: Apply for new credit every year or so and make sure you will get the new credit.
- Diversity of Accounts – Your credit score is also based on the different types of accounts you have. There are many types of accounts you can have and the more types you have, you can increase your credit score. Types of accounts include mortgages, car loans, corporation credit cards (A Chase card, for example), store credit cards, and student loans. The more types of these accounts you have can increase your score because you are showing that you can manage different types of credit responsibly. Want to meet someone with a great credit score? Chances are they have a mortgage, a car loan, and 2 credit cards. They also pay their bills on time and they often pay more than the minimum payment on their card. Takeaway tip: Make sure to have different types of accounts so that you can increase your credit score.
- Credit Usage Ratio – Your credit score calculation includes whether you have available credit and how much credit you use compared to your total credit. In order to increase your credit score, try to reduce your credit usage to 10% of your total credit. This means if your credit card has a $10,000 limit, try to keep your usage to no more than $1,000.00. If you are using more than $1,000 on the credit card, put a plan in place to get your balance down to $1,000 by paying more than the minimums each month. Takeaway tip: Keep credit usage at or below 10%.
- Credit history – How long you have had credit cards increases your credit score. For teenagers who responsibly used their parents’ accounts as an authorized user at 16 years old, their credit score has the possibility of being quite strong. Presumably, if those same teenagers continued their good financial habits through their college years. If you feared getting a credit card and didn’t do so until your thirties, chances are this will negatively impact your credit score. Takeaway tip: Get credit early and use it responsibly.
- Debt to Income Ratio – This is an important part of calculating your credit score. Your score is also based on how much debt you have, compared to your income. If you have more debt ($100,000) but your income is only $35,000, you will have a lower score. If you have debt ($20,000) but your income is $60,000, you will have a higher score. This is the unique resolution bankruptcy provides. If you file bankruptcy, in most cases you will reduce your debt to $0.00. If you are working and have an income, the bankruptcy will actually work to increase your post-filing credit score. Takeaway tip: Keep your debt lower than your income or consider bankruptcy as an option to reduce your debt.
- Paying more on your balance than the minimum – This option is the stone that kills two birds. Is that the saying? The beauty of this item is that it benefits you across many categories, not just its own. Paying more on your credit card balance than the minimum payment is a good sign to your creditors that you are responsible with money. You show the creditors that you have more than just the minimum amount, you can budget, save, and pay appropriate. The bonus here is that by paying more than the minimum, you are also addressing your debt to income ratio faster and your credit usage ratio is decreasing faster. Score! (pun intended) Takeaway tip: Pay more than the minimum balance. Make it work.