There is so much misinformation out there about how your credit works. Let me dispel the myths right now with the exact information right from Fair Isaac, the creator of the FICO scoring system that is in widespread use. Your credit score is made up of five factors:
- The length of your credit history makes up 15% of your score. In other words, how long have you had things like credit cards, home loans, and auto loans. The longer the better. DO NOT under any circumstances close old unused accounts simply to clean up your credit report. This will hurt your credit!
- Obtaining new credit accounts for 10% of your score. When someone starts to apply and get approved for numerous credit accounts, lenders worry about over extension. They see this by looking at the number of “hard” inquiries on your bureau reports. Each hard inquiry can take 2-5 points away from your score and remain on your report for as long as two years.
- The type of credit in use accounts for 10% of your score. Lenders like to see a good mix of both secured and unsecured debt. The stability of owning a home and paying a mortgage on time demonstrates to lenders ultimate responsibility. At the same time they like to see how you handle your access to unsecured debt like credit cards.
- The amounts you owe are responsible for 30% of your credit score. Typically one or even two mortgages and one or two vehicle loans are acceptable. The important thing here is your revolving debt. Revolving debt basically is made up of unsecured loans and credit cards. They can affect your score dramatically if not used properly. This is the biggest reason people have low scores and they don’t even know it. Let’s say you have a credit card that had a $10,000 limit when granted. You’re carrying a balance of $2500 right now and making your payments on time. This is a GREAT thing and is demonstrating responsibility. Your credit score is rising. The next month you go over $3000 which happens to be the first threshold a lender looks at when determining your risk. It’s called a credit utilization ratio. Whenever a CUR exceeds 30% it starts to be a concern. Hence your credit scores drop a little. Now let’s say the month after that, you carry a balance of over $5000 giving you a CUR exceeding 50%. Red flags go up everywhere and lenders become concerned. You can lose as much as 15 points. Now imagine if you have five credit cards like this. YES, multiply the number by five!!! For optimal scoring you should have a mortgage, a vehicle loan, one Visa, one MasterCard and a Discover. NO MORE! And make sure to keep the balances below 30%.
- The final piece of this pie is your payment history. It accounts for 35% of your score. Have a delinquency, a charge off, a bankruptcy…..expect your scores to drop dramatically and your risk go up. Pretty much common sense isn’t it? Lenders want to see how you’ve historically handled your finances as they determine if they want you to extend new credit to you. Yes, sometimes life gets in the way. We’ve mostly all been there. The fact remains the ultimate responsibility lies with you for “paying your bills on time”. I hear this daily. “It wasn’t my fault”. I do feel for you. Truly. Unfortunately it’s irrelevant to a lender. My experience has been succinct. If you have been wronged and it truly isn’t your fault, then do something about it. Invest the time to fight for what’s right or pay someone to do it. Back on point. Nothing in your credit report is more important than paying your bills on time. At least the ones that report to the credit bureaus.
Those are the facts. If anyone tries to steer you in a different direction, do yourself a favor and ask them to prove it! As complicated as it appears, the make up of your credit score is really quite simple. The above rules leave nothing to chance. Now there are nuances and interpretations of everything. I’m more than happy to answer any questions you might have about what you might consider a “unique” situation. Just remember, at the end of the day, it all falls within the five rules above.