From 300 to 850: How Credit Scores Are Really Calculated

As a young professional venturing into the finance world, you're about to gain a robust understanding of your credit score. This three-digit number, ranging from 300 to 850, is a key that unlocks better rates on loans, credit cards, apartments, and even cell phone plans. It's a tool that empowers you to navigate the financial landscape with confidence (Freddie Mac). Understanding the FICO scoring model, where a score above 700 is considered good, is crucial as it is the primary tool used by lenders.

At its core, your FICO credit score is determined by five main components, each weighted a bit differently: Payment History, Credit Utilization, Length of Credit History, New Credit, and Credit Mix (MyFICO).

By breaking down each of these components and providing you with tips to improve or maintain each one, I'm giving you the reins to your credit score. You have the power to influence it, and by focusing on these factors, you can steer your financial future in the right direction.

Payment History (35%)

Payment history, the most critical factor in your credit score, accounts for about 35% of your FICO score (Experian).

Picture this from a lender's perspective; you would want to see a track record of reliability. A history of on-time payments can significantly boost your score, while missed or late payments can substantially hurt it. Even one payment that's over 30 days late can deal a significant blow to your score, and severe delinquencies, such as accounts in collections, foreclosures, or bankruptcies, have even more dire long-term impacts.

Years of timely payments demonstrate your responsibility to lenders, making it crucial to maintain a good payment history.

Below are some tips to keep a great payment history:

• Never miss a due date: Always pay your bills on time, every time. Automatic payments are an excellent way to ensure you don't accidentally pay late.
• If you slip up, get current as soon as possible: Life happens, so if you miss a payment, try to pay the overdue amount as soon as you can to get your account up to date. Sometimes, companies may even forgive your first late payment.
• Monitor and correct errors: Sometimes, there may be issues or inaccuracies on the issuer's side. To prevent this, always check your credit reports for any mistakes.

Credit Utilization (30%)

Credit utilization, or the amounts owed, is the second most significant component of your score. This accounts for approximately 30% of your FICO score. It's a measure of how responsibly you manage your available credit, and it's in your hands to keep it in check.

For example, if you have a $5,000 limit and a $2,500 balance, you are using 50% of your available credit. Generally, the lower the utilization rate, the better the score.

Using a large portion of your credit lines is a red flag to lenders. It may indicate you are overextended and at a higher risk of default (not being able to repay the debt). Individuals with top-tier scores usually use 10% to 30% of their available credit.

Here are some tips to manage credit utilization:

• Keep balances (ideally <30% of your limit): As mentioned above, a guideline is to not use more than about 30% of your available credit on each card.
• Pay down high balances aggressively: If your credit cards are carrying significant balances, make a plan to reduce them. Paying off your debt not only improves your financial health but also frees up your available credit. This instantly reduces your utilization ratio.
• Consider raising your credit limits (caution): Another way to improve your utilization percentage is to increase your available credit. You can request a higher credit limit on an existing credit card if you have a substantial income or credit profile. Note that this only helps if you don't fill that new space with more spending. Use higher limits as a cushion, not an excuse to rack up more debt.
• Spread out charges or pay twice a month: If you hold multiple credit cards, consider spreading your purchases between them so that no one card is heavily utilized. Additionally, making a mid-cycle payment can reduce the balance that appears on your statement.

Length of Credit History (15%)

The length of your credit history refers to the duration of your credit usage. This accounts for approximately 15% of your FICO score. This factor examines the age of your accounts, including the oldest, newest, and average age of all your accounts. A more extensive credit history typically boosts your score, as it gives lenders more confidence in your experience managing credit.

All else being equal, someone with over 10 years of credit experience will have an advantage over someone with only 1 year of credit experience.

The main trick to improving this is to use credit smart over the long term, but here are some other ways you can build a strong credit history:

• Avoid closing your oldest accounts if possible: The longer an account remains open and in good standing, the more it positively contributes to your credit age. If you have an old credit card with no annual fee, it often pays to keep it open and use it occasionally. Closing an old account will shorten your average credit history length, especially once it is removed from your credit report in the future.
• Avoid frequent account churn: Refrain from opening and closing credit accounts impulsively. For instance, opening retail store credit cards to get a discount and then never using them can clutter your credit report with young accounts. Stick to a stable set of accounts for the long term to naturally lengthen your average account age.

New Credit (10%)

Whenever you apply for new credit, whether it's a credit card, auto loan, or any other type of loan, it can have a modest impact on your credit score. New credit activity makes up about 10% of your FICO score. This looks at recent credit inquiries and newly opened accounts. Opening a large number of new accounts in a short period is viewed as a risky move, as it may indicate a rapid accumulation of debt.

The good news about this portion is that the effect of new credit is usually minor and short-lived. For most, a single credit inquiry might knock less than 5 points off your score, and your score will often bounce back within a few months as long as you manage any new debt responsibly.

Credit scoring models also understand "rate shopping," so if you are shopping for a single loan like a mortgage, student loan, or car loan, and you submit multiple applications to compare rates, the algorithms typically count those various inquiries as one inquiry (as long as they occur within a short window, usually 14-45 days). This allows you to obtain the best rate without negatively impacting your credit score.

Here are some tips for handling new credit wisely:

• Limit how often you apply for new credit: Every new credit application can ding your score a bit, so don't apply for multiple credit accounts on a whim. A good rule of thumb is to space out credit applications.
• Plan ahead for significant credit needs: If you know you'll need a considerable loan, try to avoid opening other new accounts right before or during that time.
• Use rate-shopping windows for loans: When shopping for a mortgage or auto loan, submit your applications within a focused time frame so they are counted as a single inquiry on your credit score.
• Take advantage of pre-qualification: Many issuers and lenders offer pre-qualification checks that don't affect your credit score. These use "soft" inquiries. Using these can avoid unnecessary hard inquiries.

Credit Mix (10%)

The final component of your credit score is your credit mix. This is the variety of credit types you have and contributes roughly 10% to your FICO score. There are two major types of credit: revolving credit (e.g., credit cards) and installment loans (e.g., mortgages, car loans).

Having experience with both kinds can give your score a slight boost. That said, credit mix is not a game changer compared to other factors, and you shouldn't go out and open loans just to have one of each. In fact, you do not need to have every type of credit to have a good score.

Many people achieve excellent credit with just a couple of well-managed credit cards and one installment loan.

Here are some tips for a healthy credit mix:

• Don't sweat it if your credit mix is simple: If you are just starting out, you might only have a credit card or a student loan. You can build a great score with even one or two accounts. Over time, as you naturally need different types of credit, your mix will diversify.
• Only take on new types of credit when needed: Don't open a loan or line of credit solely to improve your mix. New accounts often come with inquiries and debt obligations, which can be more detrimental than beneficial if they're unnecessary.
• Consider credit-builder products if you have a thin credit file: If you have no credit or just one account and are looking to build credit, tools like a credit builder loan or a secured loan can introduce an installment trade line to your credit mix. These are small loans designed to help establish credit. Use them only if necessary, though; one well-managed credit card can also build your credit over time.

Conclusion

Understanding these five factors gives you the power to improve your credit score and your financial opportunities. Remember that not all factors are equal. Payment History and Credit Utilization carry the most weight, so concentrating your efforts in these areas will yield the most significant results.

That said, building credit is a marathon, not a spring. You can't gain 10 years of credit history or suddenly have a perfect mix of accounts, but you can make wise choices today that boost your score relatively quickly.

Over time, the benefits of good habits compound. If you adopt responsible credit practices and stick with them, you'll likely see steady improvement in your score.

In summary, pay your bills on time, keep your balances low, open new accounts sparingly, and let your credit history mature gracefully. Do that, and you'll be well on your way to an excellent credit score. With strong credit, you'll have greater financial freedom. Whether it is qualifying for that first mortgage on your dream home, getting a low interest rate on a car loan, or simply having the peace of mind that you've built a solid financial reputation. Good luck and happy credit building!

Disclaimer: This content is for informational purposes only and does not constitute financial, investment, or legal advice. Always do your own research or consult a licensed financial advisor before making any investment decisions. Investments carry risk, and past performance is not indicative of future results.