One of the most popular questions I’ve received since starting this site has to do with building and maintaining a strong credit score. For all the jingles and commercials floating around the airspace, many young people haven’t learned the basics of credit scores—how they’re calculated, how to build strong ones, and why they matter. Next week’s article will discuss why credit scores matter; this week's article tackles the prior two questions.
Did you know that there is not one universal number referred to as your credit score? In fact, there are three different major credit bureaus in the United States, whose task is to assemble information relevant to your credit rating. That information can be pieced together in different ways, potentially resulting in vastly different credit scores depending on a specific score’s algorithm. Some lenders even have their own proprietary rating formulas, which they use to assess potential borrowers. With all of this confusion about credit scores, how can young people begin to make sense of their own credit level? Fortunately, there's a way.
One good introduction to credit scores is to analyze the components that determine one of the most prevalent scores. I will focus mainly on the FICO credit score, the most widely used credit rating for individuals in the US. While it is not an exact model of the other scores, it does provide insight into the kinds of things that lenders care about in their borrowers.
Here is a breakdown of the different factors that affect your FICO score:
Roughly 35% of your score is dictated by your payment history. To maintain a strong rating in this category, avoid late payments, or worse—missing payments altogether. Lenders want to see that you can be trusted to pay your bills on time, whether those bills be for credit cards, a car payment, or a small-business loan. Have trouble remembering to pay your bills? Try setting a consistent time every month to pay your bills, and use your computer, phone, or some other method to set an electronic reminder. If your difficulty is that your bills are all due at different times, try calling up your credit card company and seeing if they can change your payment schedule; it doesn’t hurt to ask.
About 30% of your score is determined by your credit utilization ratio. This portion is a bit murkier than payment history, where the clear goal is simply to pay your bills on time. For FICO, your credit utilization ratio is defined roughly as the amount of your revolving balance (the unpaid amount on which you are paying interest) divided by your total credit available. In other words, if you leave a $200 balance on your card at the end of the month, and your total credit line is $1000, then your credit utilization ratio is 20%. A good benchmark here is to avoid any credit utilization ratio above 50% because it indicates that you’re really bumping up against the total amount of credit you have available.
Ideally, you probably want this ratio to be as low as possible to avoid paying interest on your balances. Sometimes people will recommend leaving a balance on your credit card to demonstrate your ability to pay it off over time, but that just costs you money in the meantime. Plus, you come off as a trustworthy borrower by simply paying off the balance upfront. Leaving a balance on your card, on the other hand, is costly both in terms of interest payments and in terms of your payment history.
Approximately 15% of your score is based upon the length of your credit history. Unfortunately for young people, this fact means that it is difficult to build up an immaculate credit score, at least right away. Even if you pay your credit card promptly and in full each month, there will still be a ceiling on the size loan you can secure until you develop a more sizable track record.
On the bright side, though, this fact also means that if you establish good habits early, your credit score is likely to rise over time simply by maintaining those good habits. Plus, there are things you can do in the short-term to help your credit history build. For example, if you have a credit card, you should purchase something with it each month, even if you could make the purchase in cash, to keep the card active and to expand your payment history. Even if the purchase is just something small from a convenience store, it still demonstrates an amount of credit-worthiness, and that purchase history can really add up over time.
On the bright side, though, this fact also means that if you establish good habits early, your credit score is likely to rise over time simply by maintaining those good habits. Plus, there are things you can do in the short-term to help your credit history build. For example, if you have a credit card, you should purchase something with it each month, even if you could make the purchase in cash, to keep the card active and to expand your payment history. Even if the purchase is just something small from a convenience store, it still demonstrates an amount of credit-worthiness, and that purchase history can really add up over time.
Roughly 10% of your score is determined by the types of credit you use. FICO considers a variety of different credit opportunities—for example, mortgages, payday loans, and revolving credit such as credit cards—and in general FICO wants to see an ability to effectively manage different types of credit. Of course, not all these types of credit will boost your score: A high reliance on payday loans, for instance, could indicate financial instability because of a constant need for quick cash to make your expenses work. I would not concern myself too heavily with this area for now; it is difficult to build it up until you are really in a position to be taking out car payments and the like. Your energy is probably better spent focusing on the above categories.
Finally, the last 10% or so of your score is determined by recent requests for more credit. Applying for loans or expanded credit can negatively affect your credit, particularly if you undertake a bunch of these all at once. Such actions can indicate rough financial times to the different credit unions, and as such, you are likely to be perceived as a more risky borrower.
This impact does not mean that you should never search for more credit, however. For instance, getting access to a larger line of credit might push down your credit score when you initially apply, but it could later boost your score by lowering your credit utilization ratio (described above)—that is, your total credit would be higher, so your remaining balance would be a smaller proportion. In general, applying for credit is a necessary evil, and as long as you don’t overuse the practice, short-term drops in your credit score should not cause significant harm to your credit score in the long-run.
This impact does not mean that you should never search for more credit, however. For instance, getting access to a larger line of credit might push down your credit score when you initially apply, but it could later boost your score by lowering your credit utilization ratio (described above)—that is, your total credit would be higher, so your remaining balance would be a smaller proportion. In general, applying for credit is a necessary evil, and as long as you don’t overuse the practice, short-term drops in your credit score should not cause significant harm to your credit score in the long-run.
Although the factors above apply specifically to your FICO credit score, the advice for the categories holds true more or less across the board. The principles of building your credit score are fairly simple: Borrow a certain amount of money; demonstrate your ability to pay it back promptly and in the correct amount; and work your way up to greater trustworthiness over time by repeating the pattern and by paying off gradually larger amounts.
Title photo from above is available here. FICO breakdown photo is available here.
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