Understanding Your Credit Score: 5 Important Factors to Consider

Our last post on how to start flying for free got a lot of interest; in less than a week, it’s become our most read post! If you’ve read the post, you know that a large part of getting free flights revolves around signing up for credit cards which give you large signing bonuses, typically in the form of frequent flyer miles. As I’ve mentioned before, we’ve collected almost two million points by applying for many credit cards over the last three years and collecting a bonus each time. Obviously, signing up for these cards has an effect on our credit scores, and most people are rightly concerned that the effect will be negative and hurt their ability to get credit cheaply for important future purchases such as a house or new car. To put you more at ease, today I’m writing a post about understanding your credit score. We’ll cover all the important factors used to derive your score, and explain how signing up for a couple credit cards could actually be beneficial to your score in the mid to long-term.

I also received a question from a reader which I will make sure to cover, which goes as follows:

“Explain to me how canceling cards doesn’t hurt your credit score. We bought a house so we will be buying lots of things soon, so I could get two or 3 new cards, but I don’t want hurt my credit in case we need a new car soon”

This is a great question.  In many cases you’ll want to cancel a card when the annual fee comes up again after a year. However, there are certain cases where you’ll want to keep the card. I’ll go over these in this post as I explain the different components of your score.

I’m also a big fan of signing up for multiple new cards when you have some large one time expenses coming up, as it makes it easy to reach the spending requirements for each card (We collected a lot of miles thanks to our wedding expenses and then our remodeling expenses over the last couple years). However, make sure that you can pay the bill in full when its due a month later. Otherwise the interest you’ll pay could end up costing more than the rewards you got. If you happen to have a significant other, it’s also a great idea to each get the same card, rather than having one person apply for both. This way each score is impacted just a bit, rather than the larger impact on one person. Of course this works best if both people have similar scores.

The Five Factors Affecting Your Credit Score

The credit score used by almost all banks and other lending agencies to determine whether or not they will give you credit is known as the FICO score. FICO calculates the score for each of the three credit bureaus (Experian, Equifax, and TransUnion) based on information in the credit report each has on file for you. This is a key point: each credit bureau can and will have a different score for you, based on what has been reported to them. Many credit cards will only pull scores and report to one or two bureaus, which means that signing up for a new card may not lower each bureau’s score.

With that said, lets look at the five main factors affecting your credit score, starting with a chart courtesy of MyFico.com. MyFico is an excellent resource if you want to learn more about FICO scores. I’ve paraphrased some of their main points and added my own thoughts for each category below.

Five Factors Used to Determine Your FICO Score

Found on: http://www.myfico.com/CreditEducation/WhatsInYourScore.aspx

Payment History (35%)

This category is the most important in determining your credit score, since lenders are especially interested in knowing whether or not you will pay them back.

• A large portion of this category is simply based on your payment history; do you have any late payments, did you miss any payments, etc.
  If you have late payments, these will affect your score less if they happened a longer time ago.
  Tip: If you happen miss a due date by a day or two, banks typically won’t report it as being late, so just make sure to pay right away if you notice this.
• Your payment history is considered for any type of loan which is reported, including credit cards, retail accounts (such as a Gap Card), mortgages, car loans, student loans, etc.
• It also includes any public record and collection items such as foreclosures, liens, lawsuits and bankruptcies (these stay on your record for 7-10 years).

Notes:

• This category typically takes the longest time to improve, since past problems will remain on the report for many years. However, its important to note that even bankruptcies come off the report after enough time, so if your score is low due to this factor, you can still improve it by simply paying all your bills on time.

Amounts Owed (30%)

This is the other large category in determining your credit score. Lenders want to make sure that you don’t owe too much compared to your past demonstrated ability to pay.

• The score takes into account the total amount owed on all types of accounts, but also breaks that out by type of account (e.g. credit card accounts and installment accounts such as car loans would be two different account types). Most of us who graduated in the last 15 years will have student loans as an installment account.
• A key component of the formula is based on your credit utilization percentage, rather than strictly on the total amount of debt outstanding. Lenders don’t like to see people close to maxing out their available credit; that makes them seem like poor credit risks.
• Lenders like to see that installment loans have been paid down consistently, and that you aren’t using a large portion of your total available credit.
• However, they do like to see you using some of your credit. Thus, its good to spend some money on your credit cards every month as long as it’s not too large a percentage of your total.

Notes:

• Because of this factor, in many cases people will actually see their credit scores rise a few months after getting a new credit card if they only have one or two. To understand why, lets review the following tables
  
• In the first example, the person’s utilization percentage is high because their total revolving credit limit is low, only $2,000. Even if they only spend $1,000 a month on their cards for regular purchases and pay the cards in full each month, their high utilization of 50% is almost certainly hurting their overall score. Getting a new card with a $3,000 limit and maintaining the same spending habits will drop their utilization level to only 20%, which would likely give them a boost to their score after a couple of months. The boost may even be more than the 5-7 point drop they initially took to their score for the new application.
• Canceling  a card can have the opposite effect; your score might drop if the lost credit line increases your utilization percentage too much. However, there are ways to mitigate this. As an example, lenders will sometimes let you transfer part or all of the credit line to another card with the same lender. It’s important to note that it’s almost always better to close a card rather than pay an expensive annual fee simply to keep the available credit.

Length of Credit History (15%)

Customers with longer histories of payment naturally tend to be better credit risks, as they have the history to prove it.

• The FICO score takes into account the age of your oldest accounts, your newest accounts, and the average age of all of them
• All accounts, opened or closed, are considered in the average. However, closed accounts will fall off your report completely after 10 years.

Notes:

• Closing an account will not negatively affect your score, except due to the drop in total available credit, which affects your credit utilization. This account would fall off your report after ten years, but at that point other open accounts will be much older and it won’t be a big deal.
• Don’t close accounts unless there is a good reason to do so. Closing an account in order to avoid paying the annual fee is a good reason.
• If you only have a few open accounts, then getting new accounts can potentially lower your average age quite a bit. In the short run you will likely see your score drop, but in the medium to longer term, the additional available credit should more than make up for it and your score should go up.

Types of Credit in Used(10%)

FICO takes the different types of credit you’ve used, including credit cards, retail accounts, mortgages, car loans, student loans, into account

• This is not typically a large portion of your score, but can be in cases where someone has relatively little credit history.
• This factor is a reason why it can be a good idea to sign up a credit card. If your credit file is small it can really help out your score, as long as you use the credit responsibly.
• As noted earlier, closed accounts will still show up on your report for many years, so don’t hold off on paying down car loans or student loans simply because you want the account to remain open.

New Credit Inquiries (10%)

Research has shown that people with too many recent credit inquiries compared to their report tend to be higher credit risks. This makes sense logically as someone in dire need of credit will be more likely to go looking for it.

• The impact of a new credit inquiry will depend on many other factors such as: How long its been since you last made an inquiry, how many recent inquiries you’ve made, and how many total account you already have.

Notes:

• Most people are way too concerned about the impact of signing up for a new card. Typically, each new application will only drop your score 5-10 points in the short run, but might even boost your score in the long run because the new credit lowers your utilization ratio.
• It’s also possible to minimize the impact of signing up for multiple new cards by making sure that the companies report to different credit bureaus. For example, in Iowa, Chase only reports to Equifax, whereas Citibank reports to Experian. So you can apply for a card with each company and only see one new inquiry on each credit report.

This covers all the factors used by FICO to calculate your credit score based on the credit report each credit bureau has on you. I hope you’ve picked up on the fact that applying for new credit has an impact on your score. That negative impact may not be as large as feared in the short run, and it can actually help improve your score in the long run. Of course, that assumes that you maintain reasonable credit utilization ratios and pay all your bills on time.

This post has gotten quite long, so I will cut it off here. I’ll be putting together a couple more posts; one on how to improve your credit if it’s not where you want it to be, and another one explaining what kind of scores you’ll want to have if you plan to get a mortgage or car loan, or simply be approved for the best credit cards.

Please feel free to email, Facebook me, or leave a comment if you have any questions.