Credit Score

How your Credit Score is Calculated

Before we get started we need to answer one question – What is a credit score?

Your credit score is a numerical measurement of how predictable you are to a lender. The higher your score the more likely you are to pay back all of what you borrow. Your credit score can affect your ability to get credit, the terms of that credit, and even your employment. Employers often check the credit history of applicants because they believe a high score signals a person is responsible.

There are 5 Factors affecting your credit score.

I’ve listed the 5 factors in order of importance. The percentage indicates how much of your score each category accounts for; notice that the top two categories are much more important than the others.

  1. Payment History – 35%
  2. Credit Utilization – 30%
  3. Credit Age – 15%
  4. Credit Mix – 10%
  5. Credit Inquiries – 10%

Let’s spend a little time discussing each category:

But First…

I use Credit Sesame to track my credit score online and for FREE. What I love most about Credit Sesame is that it gives a grade for each of the 5 factors. This way I know exactly what is driving my number. If you sign up for an account by clicking this link you will get immediate access to your credit score and report absolutely free.

Credit Score

Ok, now on to the factors!

1. Payment History – 35%

The biggest factor affecting your credit score is making ontime payments. That’s it, it is literally that easy, pay your bills on time and you probably have a good credit score.

How late you are matters. If you’re 5 days late because you blanked on a due date it won’t affect your credit score as long as you catch-up within 30 days. If you never pay a debt it will hurt your score for the next 7 years.

Recency also matters, if your late payment was 2 months ago it will hurt your score more than a late payment that was 2 years ago.

Why it matters to credit issuers: This is pretty obvious. The most important thing to a lender is that you pay them back; a good indication you’ll do that is if you’ve paid everyone else back.

How to improve: Pay your bills on time.

2. Credit Utilization – 30%

The next biggest factor measures how much of your available credit you’re actually using at a given point in time. The reporting agency takes a snapshot of your total outstanding balance 1 day a month and compares it to your total credit limit. This is not how much is due on your bill at the end of the month, but instead is literally a real-time look of how much you’ve swiped for on your cards and haven’t paid back yet.

The formula for credit utilization is: outstanding credit balance divided by credit available. The lower your percentage the better.

Why it matters to credit issuers: A small credit utilization indicates you’re responsible. It’s a little counter-intuitive, but having a lot of credit available to you and not using it shows you have self-control.  Before a credit card company gives you a new card they want to know you’re not going to use it to buy 3 boats and get yourself in trouble. A low utilization basically signals that you can already get yourself in trouble and you haven’t yet, which means you probably won’t. 

To illustrate, imagine if you give your kid a pack of Oreos and tell her not to eat so many she spoils her dinner. If she only eats a single Oreo and has a hearty appetite come dinner time, you’ll be more willing to trust her alone with Oreos in the future. Conversely, if you only give her 1 Oreo and the same scenario unfolds, you won’t be any closer to predicting if she can be trusted with an entire pack.

How to improve: Pay your entire balance in full and increase your credit limits. This is just math, to get a smaller percentage you want a small numerator and large denominator. Learn how to optimize this category by reading 1 Simple Trick to Improve Your Credit Score.

3. Credit Age – 15%

Credit age is the average of how long you’ve had your credit accounts – longer is better. It only includes your accounts that are currently open.

Why it matters to credit issuers: Experience counts for something on your credit score. Issuers like dealing with the known, and a long history of being responsible with credit makes you predictible.

How to improve: Keep your oldest credit cards open forever. If you want to close a card, close one of your newer ones.

4. Credit Mix – 10%

Your credit score is impacted by how many different types of credit you have – the more the better. The different types of credit that count are mortgages, car loans, student loans, credit cards, and personal loans.

I’m really glad this category has a low percentage because it is stupid. A person with two mortgages, student loans, and a Tesla car note will score better on this category than a person with no debt and a paid off house. That just doesn’t make sense.

Why it matters to credit issuers: They want to see that you can manage multiple types of debt without being overwhelmed. The credit card company wants to know you’ll be able to handle a new account and managing many types of accounts signals responsibility. This goes back to credit issuers hating the unknown. If you only have one credit card and nothing else, they just don’t have enough information to predict what you’re going to do – and your credit score is driven by two things: how responsible you are and how predictable your behavior is.

How to improve: Don’t. Seriously, don’t worry about improving this because it’s dumb and it counts for incredibly little. Having different types of debt might make you more predictable to credit card companies but it is not a good personal financial decision.

5. Credit Inquiries – 10%

The final factor is the number of times your credit report has been accessed by a potential lender in the last 2 years – the fewer the better. It’s important to note this only counts something called “hard pulls”, which means you actually applied for financing. If you simply check your own credit on a free credit monitoring site (like Credit Sesame) a “soft pull” is performed. A soft pull does not count as a credit inquiry. You can check your credit report 5 times a day on 5 different credit monitoring sites and it won’t impact your score.

Why it matters to credit issuers: The potential lender wants to know that what your credit history says about you today will be true in the future. Having a lot of recent credit checks by other lenders signals you are considering taking on additional debt, which might make you less likely to pay them back.

How to improve: Don’t. Once again this counts for so little it really doesn’t matter. This factor also has a very short history (2 years) so even if it is hurting your score it will cycle out soon. The only caveat is that you may want to limit your new credit applications before applying for a home loan. Also be aware that if you shop around for loans (trying to get better rates) any time they do a hard pull on your credit it will count as a credit inquiry, even if you don’t ultimately do business with them.

Wait, why isn’t income a factor?

I find this to be a very interesting question. You would think the amount of money you make would be a factor in your credit score, but it is conspicuously missing.

The reasoning is that lenders don’t care how you pay them back, only that you do pay them back. In their eyes if you have a history of making payments on time it’s evidence enough you aren’t borrowing more than you can repay. As long as you send them cash every month they don’t care if you’re making payments with money from a paycheck, a trust fund, or if your grandma is paying it for you.

This leads to an important point

Lenders are not determining what an appropriate amount for you to borrow is. They do not consider the lifestyle you want or when you want to retire. They are going to give you as much credit as they think you will eventually pay back.

You have to determine what is right for yourself. Do not ever make financial decisions based on how much credit a stranger is willing to give you.

And most importantly, never carry a balance on your credit card! Don’t freaking do it. Credit card debt is an emergency. It’s poison that kills your financial future. I mean I don’t think you should have any kind of debt (a mortgage maaaaaybe) but if you do have credit card debt you need to start acting like your hair is on fire. Seriously, stop reading this, and start reading this. (One of Mr. Money Mustaches all-time great posts)

Ok. I think that’s enough of an aside.

I hope this has been helpful in understanding how your credit score is calculated. If you have any questions or thoughts please share.

One Big Takeaway

The reason I became curious about how my credit score is calculated is because I was interested in signing up for multiple credit cards in order to earn the signup bonuses. I read about people who were travelling for free using miles earned from credit cards. I was skeptical of doing this for myself because I was worried it would devastate my credit score. It did not. My credit score actually improved when I signed up for more credit cards! This game makes no sense. I wrote a post specifically about why it’s ok to sign up for credit cards just for the bonuses (click here to check it out).

And one last plug…

Make sure you signup for a free Credit Sesame account to see how you grade in each of the 5 factors.

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