How is a credit score calculated?

In preparing for your financial future there are many things that can impact it, from the job you choose, to how much you save every month, how much debt you choose to take on, and how you manage your credit. However, one thing I’ve noticed is too few people understand how credit works. Most people begin building credit fairly young by either getting a credit card or by getting student loans, often it’s the latter. This means we end up with an entire generation of young adults who have some credit but largely because it’s thrust upon them at a young age by older adults. There’s a real lack of understanding out there, and we are going to dive into credit and it’s determinants and why it’s important.

Credit Score:

                First off, we need to determine what a credit score actually is. A credit score is just a number between 300-850 that helps banks determine if they want to lend you money or not. The credit score number was created by the Fair Isaac Corporation, or FICO. It was created by two individuals named Bill Fair and Earl Isaac who wanted to create an impartial scoring system. They started that company in 1956 and started selling their scoring system after two years.

Prior to this system most loans were determined upon more “social” and arbitrary indicators like if you were a well-known person within the community or if you looked the part of a wealthy person. But now we have a more objective method of scoring people based on a variety of historical data points collected by banks and credit bureaus. So what data points are they using to rate your credit worthiness?

Credit determinants:

There are 6 total data points that credit bureaus use to determine your credit score number. These are Payment history, Credit card utilization rates Derogatory marks, Age of credit history, Total credit accounts, and Hard inquiries.

1. Payment history:

The first and, hopefully, most obvious is the payment history. This has a VERY HIGH impact on your credit score. Even missing one payment in the first couple of years could have a huge impact on your credit score. For example, in order to be in the “healthy range” for payment history you have to make 98% or more of your payments on time. If you’ve had a credit card for less than 5 years then that’s a max of 60 total payments you could make on that one card. If you missed even two payments, your credit score falls due to missed payments. Making 100% of your payments on time is almost a must with keeping good credit. One way to do this is to set up auto payments so you never forget. The next, is to just immediately pay your credit card off when the amounts post to the card. Further, remember that a payment doesn’t have to be the full amount of the balance, it just has to be whatever is the minimum payment on the card before the card’s due date. But if you’re afraid of how to use a credit card responsibly, check this article out.

2. Credit card utilization:

This one is perhaps not as obvious but it still has a high impact. And likewise, this one is also arguably easier to control and manage. Card utilization is just about how much credit you put on the card out of the total amount of credit given to you. So, if a person has a credit limit of $5,000 and they put a $1000 dollar TV on the card, they have a credit utilization of 20%. As a rule of thumb try to keep your credit usage under 30% but an even better idea is to keep it under 10% as keeping it between 0-30% keeps your credit in the “healthy range.” Any more than that and credit scores drop. Further, credit usage across your different accounts is used as a metric too but the biggest factor is each credit card’s utilization. So, remember, if there are multiple credit cards keep all of them under 30%.

3. Derogatory marks:

Derogatory marks are things like accounts that are unpaid and sent to collections (an example might be an unpaid medical bill that someone forgot about), a tax lien placed on a house due to unpaid taxes, a bankruptcy, or a civil judgment against an individual placed by a court. In general, avoiding derogatory marks are pretty simple, don’t forget to pay your taxes and bills and try not to get sued. But if life happens and a derogatory mark does get put on a person’s record lifting them can be difficult and even one can push your credit score down. They often remain on record for 7-10 years. However, if anything is off about the mark, immediately dispute it because sometimes it will get recalled. And if it’s a collections issue, paying off the debt can remove the mark as well.

4. Credit age:

Credit age is fairly simple but among one of the harder ones to build. It takes how long you have been on various credit accounts and averages them. So if a person has two credit cards, one that’s 5 years old and one that’s brand new, your credit age is 2.5 years old. If a person is just building credit, it will take a long time for this category to get into the green. In order to have a healthy credit age, one has to have an average age of 7-9+ years across all credit accounts. Fortunately, credit age is only a medium impact on credit score, as opposed to the first three – payment history, credit usage, and derogatory marks.

5. Total accounts:

Total accounts are also a factor in credit scores. However, this has a “low impact” on credit scores so it shouldn’t be too much of a concern. Using various account types like student loans, credit cards, and a mortgage all are various lines of credit and all count towards total accounts. One important note is that once you pay off a student loan or mortgage, it will typically drop off your credit report and your score might drop once you pay it off.

6. Hard inquiries:

Hard inquiries are simply things like credit applications. These can stay on your credit report for up to two years but their effects fade overtime. Generally, keeping to only having 1-2 credit applications per year is a good idea – getting anymore can negatively impact credit scores. However, hard inquiries are also a low impact category, but keeping the amount of credit applications done in a year to one, is a great rule of thumb.

Summary:

In general, the three most important things to remember about using credit is to make on time payments, keep credit usage down, and avoid derogatory marks. Doing those three things will keep your credit score healthy. And as a back of mind reminder, don’t apply for too many lines of credit in one year.

Lastly, if you are trying to get your credit score under control using YNAB is a great resource and getting started using a budget is a great starting point. But if you’re already past that and are trying to build wealth and want to invest, try using m1 finance (you’ll get an extra $10 dollars with the referral link) it’s a great platform for long term investing. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.

Note: the m1 referral link gives the reader $10 extra dollars to invest with if they choose to fund a taxable with $100 dollars within 30 days of opening the account or fund an IRA with $500 within 30 days of opening an account. The author of this article will receive a $10 dollar compensation as a result of the reader opening an account. The compensation for both parties occurs 30 days after the deposit occurs and assumes the full amount is retained in the account until the end of 30 days from the deposit day. YNAB offers a free month of use this will be given to both the author and reader if the reader subscribes after the free trial period and buys a month of subscription. The author uses and endorses both YNAB and M1 Finance and both links are affiliate links.

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