This is a 5,000+ word guide on how to become a master of all things credit and credit scoring.
Yup, you read that right. 5,000+ words.
I am not a big fan of using 5,000 words when 500 will do, but a topic this important demands a thorough write up.
First, because your credit score is a vital part of your financial health, and therefore your overall well-being.
Bad credit = more stress, more frustration, and more money needed to buy things like houses and cars. (Read: less freedom)
And secondly, because 90% of the things that you read and hear about credit scores are completely false.
Everybody thinks they understand credit scores when in truth, less than 10% of these people have any idea what they’re talking about. (10% figure based on my own experiences. Scientific accuracy be damned)
Today you become a part of that educated minority.
Over the next 5,000+ words you’ll learn everything you’ll ever need to know about credit and credit scoring.
Go ahead and bookmark this page because you’ll probably want to refer back to it a time or two.
At the very least it will help you diffuse your friend/roommate/coworker/neighbor who keeps telling you that credit cards are evil and to be avoided at all costs. (Face palm)
Ready? Let’s get started.
Here’s what we will be covering today:
Why Should You Care About Your Credit Score?
Let’s start by addressing the elephant in the room. Why should you care about your credit score (and therefore keep reading this 5,000+ word post)?
I was actually having dinner with some friends the other day when this very question came up. I know, we are quite the conversationalists.
My response was cut off mid-sentence by the question “Credit scores? What are you, 50 years old now?”
It’s that kind of ignorance that causes years and years of financial stress.
The fact of the matter is your credit score will dictate how much money you pay for the largest purchases you will make in your lifetime.
The $250,000 home that you want to buy someday?
It’ll cost you an extra $31,000+ in interest if your credit score is less than ideal.
Which is more than enough money to buy a large pepperoni pizza every single day for 7 years… 7 years!
The same effect can be seen with auto loans. You can play with the numbers here if you like.
So unless you aren’t a fan of pizza, or saving thousands of dollars on life’s biggest purchases, you should probably listen up.
Step one: understanding your credit report. This is where it all begins.
What Is A Credit Report?
A credit report is a detailed report that contains information about your credit history.
Some things that are included are the status your credit accounts, loans, bankruptcies, late payments, credit inquiries, public records, and even some personal information such as your address, social security number, and date of birth.
This information is collected by the three major credit reporting agencies (Equifax, Experian, and TransUnion) and each one compiles it in to their own single credit report.
Although each reporting agency has their own credit report, the information that each of them collects is very similar.
The credit reporting agencies then sell this information to businesses such as banks, credit card companies, insurance companies, and even landlords, where it is used to determine your creditworthiness.
Still with me? Great.
Let me make a quick analogy.
Think of your credit report like a transcript or report card from school.
It is simply a record that shows what classes (or in this case credit accounts) you have taken and what grade you received in each of them.
Like a school transcript, your credit report does not explicitly state whether you are a “good” or “bad” student (or credit). It simply presents the historical information that has been gathered.
What Is A Credit Score?
Your credit score, on the other hand, is a numerical assessment that quantifies the risk that you present as a credit. It is used by lenders to answer the question “How much risk am I taking by lending money to this person?”
So if your credit report is your report card, your credit score would be your grade point average (GPA).
Your credit score is calculated by taking information from one of your credit reports and running it through an algorithm created by a company called FICO (formerly called Fair Isaac Corporation). The algorithm uses the information found on your credit report to generate a number between 300 and 850 that represents the risk you present as a credit.
The higher your score, the less risk you present as a credit, and therefore the more likely you are to qualify for lower interest rates on any form of debt.
While there are a variety of different credit scores that are used by lenders, the FICO credit score is by far the most common.
Let’s take a look at how it is calculated.
How Your Credit Score Is Calculated
Your credit score is calculated using the following 5 criteria:
1. Payment History (35%)
The most important factor in determining your credit score is your payment history. This measure reflects the number of times that you have paid your credit bills on time.
The more on-time payments you make, the higher your score will be.
It is important to note that bills such as rent and utilities do not contribute to your payment history. FICO does not consider these types of bills to be credit accounts, so they do not include them when calculating your score.
These items can however have a negative impact on your score if you fail to pay them and they are turned over to a collections agency.
Not only is your payment history the most heavily weighted metric, but it is also the most volatile. Miss just a couple payments and you could drop over 100 points off your score (Ouch!). That big of a drop will limit your ability to qualify for any sort of credit card or loan.
Tl;dr (Too long, didn’t read): Make all of your payments on time, every time.
2. Amounts Owed (30%)
The second largest factor in determining your credit score is the amount of debt you owe. This metric is broken down into a few subcategories.
Total Amount Owed: This is the total amount of debt that you owe on all of your credit cards, loans, etc. Generally speaking, the less debt that you have the better your score will be.
Having zero debt however does not guarantee a good credit score. More on that later.
Total Amount Owed by Account: This is a measure of how much debt you have on each of your accounts. Creditors commonly refer to this as your credit utilization, which is expressed as a percentage of your credit limit that you are using.
For example, if you have a $1,000 limit on a credit card and have a balance of $500, then your utilization for that card would be ($500/$1000=) 50%.
Generally speaking, the lower your utilization, the higher your credit score will be.
The exception to this rule is having 0% utilization. 0% utilization indicates you don’t use credit, which research has shown is riskier than using some credit. So 0% credit utilization could have a negative effect on your credit score.
It’s also important to note that your credit utilization is not tracked historically. Only your current utilization counts, so worry about what it was last month/year/etc.
How Many Accounts Have Balances: Carrying a balance on a large number of your credit lines indicates that you may be a high risk borrower and can lower your credit score.
Original Amount of Installment Loans vs. Current Balances: Paying down installment loans (mortgages, car payments, etc.) is a good sign that you are able to manage and repay debt. Like credit card payments, you always want to make your installment debt payments on time and in full.
Tl;dr: Don’t max out your credit accounts, even if you’re paying the bills on time. Lower utilization is better, except if it’s 0%.
3. Length of Credit History (15%)
Length of credit history is a measure of the amount of time that you have been using credit. This metric takes into account the age of your oldest account, the age of your newest account, and the average age of all of your accounts. In general, a longer credit history will lead to a higher credit score.
All trade lines, whether opened or closed, will contribute to your average age of accounts until they fall off of your credit report at the 10 year mark.
Tl;dr: Don’t close old accounts just for convenience. More on this later.
4. New Credit (10%)
New credit is a measure of your credit seeking activity. By applying for and opening a lot of new accounts in a short period of time you are indicating that you might be a risky borrower, which will cause your credit score to fall.
Tl;dr: Don’t apply for a ton of credit accounts at once.
5. Types of Credit Used (10%)
This factor looks at your mix of credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. You ideally want to have a healthy balance of credit card debt and installment loans to show that you know how to manage both types of debt.
Tl;dr: Having mortgages, car loans, etc. can be beneficial for your credit score. But don’t ever take out a loan just to improve your credit score. More on that later.
Now that you know how your credit score is calculated, let’s take look at how your score is evaluated by creditors.
What Is A Good Credit Score?
As we discussed earlier, FICO credit scores range from 300 to 850, with 300 being the absolute lowest and 850 being an almost unattainable maximum.
Chances are good that your score will fall somewhere between the two, so let’s take a look at what that means.
Here is a chart that shows how credit scores are typically graded.
As you can see, credit scores are put into ranges when being evaluated by creditors.
While different creditors might use different ranges, they are generally pretty close to the ones you see above.
A quick google search will show you some of the different variations.
Scores within each range are typically treated equally, so there is no need to obsess over minor fluctuations in your score. As long as you stay within your desired range you will not see any major change in interest rates/approvals for credit cards or loans.
So continuing with our report card analogy, an A is an A, a B is a B, etc. Regardless of where you may fall within the range.
So don’t be that guy who freaks out about your credit score dropping 5 points.
It is also important to note that there is a diminishing return in having a credit score that is higher than the mid 700’s. Creditors typically treat scores in the “excellent” range equally, so you do not need to worry about trying to reach the maximum score.
How Do You Check Your Credit Score?
There are dozens of websites that promise to give you a free credit score (one particular TV jingle comes to mind), but very few of them actually do.
Most of these sites require you to purchase some sort of credit monitoring package before showing you your score. These packages typically cost $10 to $20 a month.
Do not sign up for these services. They are a total waste of money.
Instead, I recommend that you use websites such as CreditKarma.com or CreditSesame.com.
These are 100% free websites that show you a credit score as soon as you sign up. You’ll never be asked to provide credit card information or submit any form of payment.
You will have to provide some personal information, including your social security number to verify your identity and pull your credit, but rest assured you will never be charged a dime to use these services.
Websites like Credit Karma and Credit Sesame make money by advertising credit products based on your credit report or credit score. Always do your own research, as they have a financial incentive to recommend some products over others.
In full disclosure, the scores that are provided by these sites are not your actual credit score. They are simply approximations (called “FAKO” scores).
They are, however, incredibly accurate (I check them frequently against my actual FICO score) and good enough for our purposes.
If you want to see your actual FICO score you have a few options:
- Pay a monthly fee to check it on myfico.com (don’t do this)
- Have your friend at the car dealership/bank/check cashing place pull your credit (punch yourself in the face if you do this)
- Get a credit card that provides a free monthly FICO Score (Bingo)
A quick google search will tell you which cards come with this feature. You can also take a look at some of my favorite credit cards by visiting my credit card page.
Finally, you are entitled to one free copy of your credit report every 12 months from each of the major credit bureaus. You can make this request at www.annualcreditreport.com.
Remember, your credit report doesn’t show you your credit score. But reviewing it annually is a great way to make sure that everything is in order.
Be careful, there are a number of websites out there that try to mimic this site and charge you for your reports. Again, you should never have to provide credit card information to view your reports.
How To Build And Maintain A Good Score
Ok, so you now know what a credit score is, how it is calculated, how credit scores are viewed by lenders, and how to check it (for free).
But how do you make sure that you are able to build and maintain a good score?
Here are 4 tips that will help:
1. Understand How Your Credit Score Works
Your credit is one of the most valuable assets that you own and ruining it will have lasting effects on your financial well-being. For this reason, it is important that you take the time to learn how it works.
This will help you make informed credit decisions and take the necessary steps to maintain a good credit score.
By taking the time to read this overview you are already taking the first step. It may help to review it a couple times to make sure that you didn’t miss anything.
In addition to understanding how your score works, it is also important to check it regularly to avoid issues such as account errors or fraud. Remember that you should never pay to do this.
2. Always Make Your Payments on Time
Put simply, missing credit payments has the potential to wreak havoc on your credit score. Having just one or two missed payments can drop your score by more than 100 points and make it very difficult for you to qualify for any sort of loan.
You absolutely have to make all of your payments on time and in full if you want to maintain a good credit score.
If you’re worried about missing payments I highly suggest you take advantage of “auto pay” features offered by banks/credit card companies.
3. Build a Solid Credit History
The more credit history you have, the more evidence there is that you are a responsible borrower. This will help to boost your score and insulate it against minor ups and downs that can be caused by things like new credit inquiries or accounts.
The best way to build a solid credit history is to continually stick to the first two tips that you just read. If you continue to monitor your credit score and make your payments on time you will be able to build a solid credit history of being a responsible borrower.
It is also a good idea to keep your older credit accounts open and in good standing.
Although it can be tempting to close credit accounts that you no longer use, keeping them open helps to build your credit history and thus boost your credit score.
As a general rule, I would suggest that you never close any credit accounts that do not have an annual fee.
4. Keep Your Credit Card Balances Low
The last tip for maintaining a good credit score is to keep your credit card balances low. Generally speaking, the higher your credit card balance is, the lower your credit score will be.
To prevent this from occurring it is best to keep your credit utilization below 20% at all times (That’s $200 on a credit card with a $1,000 credit limit). Going above 20% could cause your score to fall, even if you are paying your balance every month.
By understanding how your score works, always making your payments on time, building a solid credit history, and keeping your balances low, you will easily maintain a good credit score.
Now let’s tackle a few common credit myths.
Common Credit Myths
Credit Myth #1: Paying cash for everything will help your credit score
The thinking behind this myth is pretty simple. Paying cash = no missed/late payments = good credit score.
The assumption being that “good” credit is the default, which is completely false.
Paying cash (or using debit cards, gift cards, checks, etc.) for everything prevents you from building credit history, which means you will likely have a low credit score.
In some cases, you might not have a credit score at all (referred to as a “thin file”).
Again with the report card analogy, you cannot have a great GPA if you never take any classes.
And if you are still using a debit card for your day-to-day purchases you need to switch to using a credit card, provided that you trust yourself to do so.
Credit Myth #2: Having too many credit cards will hurt your credit score
This is the age-old question of credit cards. What is the right number of cards to have?
I hate the answer “it depends”, but in this case it seems appropriate.
Allow me to elaborate.
As we discussed above, 30% of your credit score is based on the amount of debt that you owe with respect to your total available credit (called “credit utilization”).
In an ideal world you would always keep your utilization below 20% (i.e. $200 on a credit limit of $1,000).
Below 10% would be even better, but 20% is a good benchmark.
So take the amount of money that you spend in a typical month, multiply it by 5, and that’s the minimum amount of credit that you should have available at any given time.
If your credit limit is any lower than that then you should probably apply for another credit card or two.
But if 20% is the minimum, what is the maximum? Will having a bunch of credit cards hurt your score?
Nope, in fact that will likely help your credit score by reducing your credit card utilization and increasing your number of on-time payments.
Generally speaking, there is no such thing as having “too much credit”. As long as you are making all of your payments on time, extra available credit will actually help your score.
Credit Myth #3: Checking your credit will hurt your score
In the world of credit scores there are two types of credit checks, “hard inquiries” and “soft inquiries”.
A “hard inquiry” occurs when your credit report is pulled as a result of some sort of application for credit (credit cards, mortgages, car loans, etc.). Each hard inquiry dings your credit score by roughly 2-5 points, depending on a variety of other factors.
A “soft inquiry” occurs when you pull your own credit report or when a company pulls your report for a non-credit use such as a background check. Unlike a hard inquiry, a soft inquiry has no effect on your credit score.
So how do you go about checking your score (and not hurting it)?
I personally recommend that you use Credit Karma or Credit Sesame (or both). These two sites are very user friendly and completely free. You will never be asked for your credit card information in order to see your score.
Don’t bother with sites like freecreditreport.com that ask for your credit card info. They will end up charging you a monthly fee for a bunch of credit monitoring services that you probably don’t need.
Credit Myth #4: You should close accounts after paying them off
This myth is related to the number of credit cards myth, but the number of questions I receive about it on a weekly basis justify a separate question.
Generally speaking, you should never close a credit account unless you have a reason to.
Common reasons include avoiding an annual fee, transferring your credit to another card, etc. Never close an account just for convenience.
Closing accounts reduces your total available credit, causing your credit card utilization to increase and therefore your credit score to fall.
Closing accounts also prevents you from building additional credit history, which makes up 15% of your score.
This myth persists because people think that closing an account will remove it from their credit report, therefore hiding any bad history from future lenders.
Unlike bad relationships, you can’t just delete all of the evidence of a bad credit account and forget that it ever happened. The account will remain on your credit report for up to 10 years.
Unlike bad relationships, you can’t just delete any evidence of bad credit accounts and forget about them
The best course of action is to keep the account open and in good standing, allowing you to build credit history and maintain a good credit utilization ratio.
Credit Myth #5: You need to carry a balance to build your credit score
I have never really understood this myth. I’m supposed to believe that by not making all of my payments on time I am somehow improving a metric that measures my likelihood of making my payments on time?
Conventional credit card wisdom continues to baffle me.
The most common justification for this practice is the belief that carrying a balance on your credit card is the only way to build credit history, which makes up 15% of your score. After all, having no balance means you have no credit history right?
This is completely false.
You are building credit history regardless of whether or not you carry a balance on your card. Carrying a balance will only leave you with tons of late fees and interest charges.
If anyone tries to tell you follow this advice please do us all a favor and punch them squarely in the face.
Credit Myth #6: Paying all of your debts will instantly fix your credit score.
This is like believing that starting a diet will instantly make you fit.
The truth is that your credit report reflects your history of using credit, not just a snapshot of your current situation. Even after being paid off, it can take as many as 7-10 years for a debt to fall off of your credit report.
So if you are looking for a quick fix for your credit score, this is not it.
Credit Myth #7: You only have one credit score.
This myth is perpetuated by all of the advertisements that encourage you to “check your credit score”, as if there is only one score that is used for everyone.
I wish it were that simple.
The truth is that there are dozens of credit scoring models that are used to predict your likelihood of default. Each of them is a little different and at times can produce drastically different scores. While I would love to discuss each of them with you (actually, that sounds awful), I’ll save us both the time and cut to the chase.
The most widely used credit score is the FICO Score, which ranges from 300-850. This is the score that you want to pay attention to.
Your FICO Score is calculated from several different pieces of data in your credit report that are grouped into 5 basic categories. We just talked about how this works above.
Other credit scoring models are often referred to as “FAKO” scores. While these scores can be useful for getting a basic idea of where you stand, the FICO score is the one that really counts.
Credit Myth #8: Once a credit score is bad it can’t be fixed.
I have found that this is more of an excuse than a myth. People with bad credit tend to bring this up when they are confronted with the idea of repairing their credit score.
In reality they are simply trying to justify their laziness.
While there are certainly no “quick fixes” for a credit score, it can be rebuilt with a little bit of patience and discipline. They key is start making your payments on time and building a history of responsible credit use.
Credit Myth #9: Income/education/net worth can affect a credit score
Your income, education, net worth, etc. have absolutely zero effect on your credit score.
Your credit score is a reflection of your ability to pay your bills on time, not your current financial standing. It cannot be improved simply by earning or saving a lot of money.
Credit Myth #10: Credit reports are only used for financial purposes
In addition to being used in credit decisions, credit reports can be used by current and potential employers to aid in employment decisions. While they cannot see your actual credit score, employers are able to view a modified version of your credit report that includes information about loans and credit cards listed in your credit report.
This practice is especially common in industries such as banking or finance, where employees are responsible for dealing with a client’s personal finances.
This is just another reason why your credit score is such a crucial component of your overall financial well-being.
How To Improve Your Credit Score
Don’t be discouraged if you happen to find yourself with a credit score that is lower than you would like it to be. Your credit score is never permanent and it can be improved with a little bit of patience and the right advice.
With that said, let’s take a look five steps that you can take to improve your credit score.
1. Check for Errors on Your Credit Report
The first step to improving your credit score is to check for any errors on your credit report. Errors are relatively common and can have serious effects on your credit score if they are not addressed quickly.
Make sure to only request a copy of your report from www.annualcreditreport.com, as we discussed above. You will not have to provide credit card information to do this. If they ask for any sort of payment then you are on the wrong website.
Common errors to look for are duplicate account listings, inaccurate personal information, or identity theft.
Look over the entire report for any inaccuracies and send any disputes to the credit bureaus in writing. The bureaus are required to investigate any information that you dispute and will make corrections where needed.
Make sure to continually follow up with the credit bureaus until any mistakes are corrected.
2. Try to Pay Your Bills On Time
The next step is to do everything you can to start paying your credit bills on time. This is pretty obvious, as your payment history is the biggest factor in calculating your credit score, but it is crucial to improving your score.
Continuing to miss payments will not only prevent you from improving your score, but it could also cause it to fall even further. We definitely do not want that.
Start by targeting the accounts that are in collections first, as these are the most harmful to your score. You might even be able to negotiate a lower debt by offering to do a “pay for delete” (google how to do this), but this is not as common as it used to be.
Make sure to document all of your correspondence with your debtors and to request a “paid in full” letter when your debt has been paid. Things can get pretty dicey when you are disputing debts so you’ll want to make sure to cover all of the bases.
Phone conversations should be avoided if possible.
Then work your way up to more recent debts, focusing on the ones that are close to your credit limits first.
3. Reduce Your Spending
This step requires you to be brutally honest with yourself.
Sometimes things like medical emergencies, unexpected job loss, unforeseen car/home repairs, etc. occur suddenly and cause financial distress. I get that.
But most times bad credit is caused simply by spending beyond your means.
Regardless of what caused your credit to be damaged you are going to have to make sacrifices to fix it.
That $30 a month wine club you just joined? Cancel it.
Go ahead and drop all of those premium cable channels while you are at it.
4. Don’t Close Old Accounts
While it is tempting to close credit cards after paying them off, it is best to keep them open if you want to improve your credit score.
When you close a credit account it reduces your total available credit, which causes your credit utilization to rise and your credit score to fall. Closing old accounts can also reduce your length of credit history (15% of your score), especially if one of them happens to be your oldest line of credit.
Closing old accounts also does not make them go away. Items such as delinquencies or bankruptcy can remain on your credit report for years, regardless of whether or not the accounts have been closed.
5. Opening New Accounts
How you approach this step depends on your credit history.
If your credit score is low because you have little to no credit history then you should try to open a new credit card account. This will help to establish some credit history and start improving your credit score.
You should only apply for a card that you are likely to be approved for so it might be a good idea to start with some of the more basic credit cards offered in the market. Opting to go for a secured card might also be a good option.
If you already have an extensive credit history then you should avoid opening new credit card accounts if at all possible. Applying for cards could cause your score to fall even farther and you will likely be denied for them anyway.
Remember to be patient! Improving your credit score won’t happen overnight but it can be done with discipline and persistent effort.
That’s it! You’re now a credit score master.
Don’t forget to bookmark this page for future reference. And if you want to share it with your friends (click below) I would really appreciate it!