Demystifying Credit Scores

What’s a credit score? Why is it important? One would think something as important as a credit score would be common knowledge and taught as early as middle school, however that is anything but the case. I’ll do my best to demystify credit scores and provide a base layer of information to send you on your lifelong journey of understanding and, hopefully, improving that important number!

Who determines your credit score? The three players involved in collecting your financial and credit history are Equifax, Experian and TransUnion. A credit rating is typically a numerical score between 300 and 850. Each rating agency has a slightly different methodology, so your score can vary between them — although each agency’s score should be in the same ballpark. A credit score could also be presented as a letter grade (e.g., A, B, C, D…); this is done for individuals to have a better idea where they fall in the “credit spectrum.” 

​What determines your credit score? Broadly speaking just about everything related to your personal credit and financial history. More specifically, credit agencies are looking at five main criteria:

1. Your payment history.
2. Your level of credit utilization — I’ve read anywhere from 20% to 30% is an ideal target.
3. The average age of your existing credit accounts: How​ long has that credit card been open?
4. The composition of your credit accounts.
5. The frequency of requests by an institution for your credit information. 

How a Credit Score Is Used

Why do you need a credit score? Credit scores are used to determine whether a loan or credit should be issued to a potential borrower. The credit score determines the terms of the loan, meaning the amount of money the lender (e.g., bank) is willing to extend, at what interest rate, over how long of a period. Having no credit score can indeed be worse than having a low credit score. 

​When is your credit score used? Anytime you are applying for a loan or credit. Purchasing a car, house or boat? If you’re financing the purchase, a credit report will be reviewed by the potential lender to determine the terms of the loan. If you apply for credit, either a credit card or a security-based line of credit, a credit report will be pulled. Those two types of credit inquiries are considered “hard inquiries” and the frequency of which they are requested can harm your credit score — hard inquiries remain on a credit score for two years. “Soft inquiries” do not negatively affect your credit score. An example of a soft inquiry would be you requesting a credit report on an annual basis to check for unusual activity. 

Upgrading Your Credit Score

How can you improve your credit score? Let’s consider improvement in the context of how your credit scored:

1. Do not be late paying bills. This is about staying diligent: using auto payment when possible. When it’s not, set yourself calendar reminders. When building, improving and maintaining credit, late payments cannot be tolerated.
2. I’ve read it’s recommended to only use 20% to 30% that is offered to you. For example: If you have a credit card with a $5,000 limit, limiting yourself to spending $1,000 per month on said card and then paying off completely each due date (i.e., not carrying a balance over month to month) is 20% credit usage. 
3. The amount of time spent building credit matters. So start responsibly managing credit as soon as you can. Your credit will start low, but after years of responsible usage that score will increase!
4. Only using credit cards is not the most effect way of raising your score. Having bank loans (e.g., auto or home) and paying them in a timely manner is another component of a strong and improving credit score. 
5. Do not go on a binge to apply for credit. Adding additional accounts in a short period of time will do more harm than good. Your goal is not to have a wallet of a similar size to George Costanza, filled with credit cards (I hope my fellow millennials get that reference!). Only apply for what is needed, NOT every time a new shiny promotion is offered.

Matt Mondoux sits on the investment committee and is an adviser at Blue Chip Partners, Inc., a privately owned, registered investment advi­sory firm based in Farmington Hills, Michigan.