In this article, I want to make no assumptions about your level of knowledge on the subject; therefore, I’ll start with the basics of credit reports and credit scores (because they are two different information sets) and then move to how you can manage and improve them.
We’ll start with the most detailed of the two items—the credit report. This is a set of information that’s compiled from your past and present financial transactions and behaviors. It’s maintained on an ongoing basis and electronically follows you wherever you go. The details of the credit report are ultimately used by a handful of companies to calculate your credit score.
Reader beware—depending on your credit score, it can be a very lengthy process to get it to your desired level. There aren’t many (if any) overnight fixes, so be prepared to reap the rewards a little further into the future than you might expect.
What is it?
A credit score is a numerical representation of your level of financial risk. It is an objective, straight-forward, mathematical calculation of how risky your financial behavior has been over time. With that said, there are several different versions of credit scores, but I’ll focus on the main ones in this article (i.e. Equifax and Transunion). A higher score is better with most ranges topping out at 850.
How is it used?
Most often, a credit score (and sometimes a full credit report) is pulled when you are considering entering into a financial transaction. This may be any number of things; a few examples are:
- Purchasing a vehicle
- Buying or renting a home or apartment
- Opening a credit card
What are the components?
Below are the major components or factors that go into determining your credit score. Each has a different weight, depending on the company calculating the score.
- Payment History (HIGH): This one is a running tally of how many payments you’ve made on time versus how many you’ve made late. It’s generally calculated as a percentage of on-time payments; for instance, if you have 120 possible payments in your credit history and you’ve made 115 on-time, you would be 95.8% on-time (115 / 120 = 95.8%). It also provides more weight to significantly aged payments. For instance, a payment late by 30 days hurts you less than one that’s late by 90 days. Obviously, it’s best to keep this to 100% on-time payments if possible, but dipping into the high 90% range won’t totally wreck your score.
- Credit Card Usage (HIGH): This metric compares how much of your credit card limit you’re using and is expressed as a percentage. As an example, if your credit limit is $30,000 and your current balance is $6,000 then you’re utilizing 20% of your limit ($6,000 / $30,000 = 20%). The ideal utilization is 25% or less in most cases.
- Derogatory Marks (HIGH): This tracks relevant events in your credit history, such as: collections, tax liens, bankruptcies, civil judgments, etc. In some cases, events that show up in this section may have been outside your control for one reason or another. It’s best to keep these events off your credit history, but if you have encountered any of them in the past, the good news is they don’t stay on your report forever. As an example, I believe bankruptcies older than 7 years no longer affect your credit score.
- Age of Credit (MEDIUM): This metric captures the average age of your open accounts. If I have three accounts open—one for 2 years, one for 6 years, and another for 8 years—my average age of credit is 5.33 years (2 + 6 + 8 / 3 = 5.33 years). From a score perspective, the older your credit is, the more it helps your score.
- Total Accounts (LOW): This statistic simply tracks the amount of accounts on your history—both open and closed accounts. The logic behind this is to show that you’ve used different accounts responsibly over a longer period. The ideal amount of accounts, on average, is at least 10.
- Hard Inquiries (LOW): This captures the number of times you’ve applied for credit. An example of a hard inquiry is a credit card company checking your credit history before extending you credit. It’s best to keep this number low; less than two hard inquiries, on average, will be the best to boost your score.
How should I manage it?
As with most things in life, consistency is key in ensuring a good credit score. There are multiple free sites you can use to check your credit score at any given time. A few best practices are:
- Check your credit score often. I check mine at least once a month to ensure there aren’t any unexpected or fraudulent transactions affecting my history or score.
- Make intentional credit decisions with your score in mind. For instance, applying to multiple mortgage companies for a mortgage at one time will hammer the score. Rather, apply for one at a time as this will ensure fewer hard inquiries.
- Make on-time payments as this is the highest waiting on your credit score.
- Keep your credit card utilization less than 30%. If you go above that amount, it will start to negatively affect your score. If you routinely use 80% or more of your available credit, consider applying for a higher limit. This will result in a short-term hard inquiry but will pay off in the long run.
- Don’t go overboard with open accounts; conversely, have more than just a few. This one can be a bit tricky to manage as too much or too little both negatively affect your score. Aim for the range of 15 to 20 accounts—and remember they don’t have to all be open accounts.
- Do make use of your available credit and allow it to age. Most companies prefer to see an average age of at least 7 to 8 years.
Consistency and discipline are the best techniques for effectively managing a credit score. It’s also helpful to remember all credit scores are not created equally—one company may say your credit score is 780 while another shows 720. This is likely because they use different metrics or weight metrics differently. Don’t be discouraged if your credit score is low; it can always be improved through managing your personal finances, debt, credit cards, etc. Also, take time to educate yourself on the metrics, weightings, and calculations to arrive at your score. Then, make intentional financial choices with your credit score in mind. It’s certainly not good to obsess over the score, but consistent management toward an average to good score is much easier than allowing the score to slip to a bad range and then trying to repair it.