How Do Credit Scores Work?
What exactly is credit? Credit (at least the kind we’re talking about) is a form of trust which allows you to make purchases you wouldn’t normally be able to afford at face value. This trust is based on the understanding that you will eventually pay this sum back. Your credit score on the other hand is a numerical representation of how good you are at paying other people back. While this won’t apply to informal borrowing between friends and family, it will apply to your credit cards, student loans, and mortgage payment. People who pay their bills on time, make regular purchases, and avoid maxing out their credit cards generally have higher (and therefore better) credit scores.
How are Credit Scores Calculated?
What makes a trustworthy borrower? Basically it comes down to 5 things:
- Payment History
- Amount Owed
- Length of Credit History
- New Credit
- Type of Credit Used
What do each of these categories mean?
Payment History (35% of your score) concerns whether or not you make your payments on time. This includes both revolving loans and installment loans. Think of revolving loans as things you need to pay regularly because you regularly accumulate debt. For instance, credit card debt. Installment loans are for one-time purchases that you pay off gradually over time. For example, student loans and mortgages. Both revolving and installment loans are equally important to your payment history.
Amount Owed (30% of your score) is about how much of your available credit has been used. So, if your credit limit is $6,000 and you spend $5,999.99 every month, then that could be a red flag. Err on the side of spending less. Don’t max out any of your cards. Or if you spend more, try to pay off your balance as quickly as possible. Otherwise, this may indicate that you cannot hold onto your money or manage debt well. FICO recommends an average credit utilization ratio of less than 6%, with 3 accounts carrying balances and less than $3,000 owed on revolving (credit card) accounts.
Length of Credit History (15% of your score) represents how long each of your accounts have been open and when your most recent transaction was. Those who don’t have a long credit history can still have a good score if they maintain low utilization ratios (use less of their available credit) and have no missed payments.
New Credit (10% of your score) deals with opening new accounts. However, this doesn’t mean that opening a bunch of new accounts will improve your credit. In fact, it may seem like you’re in a financially precarious situation and need quick access to lots of credit. Opening a new account will also have the negative side effect of lowering your average account age.
Type of Credit Used (10% of your score) means having a diverse range of debt. For instance, having revolving credit and installment loans. This shows that you can handle an assortment of different kinds of credit.
Who Collects This Data?
There are 3 U.S. credit reporting bureaus: Experian, TransUnion, and Equifax. While there are many personal finance companies like Credit Karma that can do a soft pull, only the 3 credit bureaus above can do a hard pull.
- Soft pull/inquiry: This will NOT affect your credit and will give you a good idea of your credit score.
- Hard pull/inquiry: This WILL affect your credit. Used for more official purposes.
When are hard inquiries necessary?
- Mortgage applications
- Personal loan applications
- Credit card applications
- Apartment rental applications
- Student loan applications
- Auto loan applications
If you are unsure whether something requires a hard or soft inquiry, then ask! At the end of the day, it’s your credit being impacted. For more information, feel free to reach out to us anytime!