The Ultimate Guide to Understanding Your FICO Score | ModMoney

The Ultimate Guide to Understanding Your Credit Score

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Credit card spending is a great way to earn cash back, rewards, awesome travel perks, and lucrative sign-up bonuses. But to fully enjoy these benefits, you need a solid credit score. So, what does that mean? How is it calculated, and how can you find yours? Read on for everything you need to know about your credit score.

What is a credit score?

Your credit score is a metric used to evaluate your risk as a borrower. It allows prospective lenders (think credit card companies, mortgage and auto lenders) to predict the likelihood that you will make your payments on time. We can break down a credit score into the following ranges:

  • 300-580 (Poor)
  • 580-670 (Fair)
  • 670-740 (Good)
  • 740-800 (Very Good)
  • 800-850 (Exceptional)

Keeping your credit score as healthy as possible should be top-priority because it's such an important part of your financial profile. Sure, it shows up when you apply for a credit card. But it also determines the interest rate on your mortgage or personal loans, appears on employee background checks, and affects security deposits and insurance rates. It's everywhere!

How is your credit score calculated?

When you borrow or repay money, your activity is reported to the three credit bureaus: Experian, Equifax and TransUnion. Each bureau compiles a report, and that’s where your score comes from. Specifically, there are five factors that comprise the calculation of your credit score. Knowing what they are is the first step to building up your credit profile.

Breaking Down Your FICO Score

1. Payment History – 35% of your credit score

The first thing a prospective lender will want to know about you is your track record of making on-time payments. Even one or two missed payments will seriously hurt your credit score. If you are over 30 days late, the record will hit your credit report and stay there for up to seven years. Since your payment history is the largest contributor to your credit score, this is especially harmful. So avoid being late at all costs. Set your payments to autopay every month to remove any risk of forgetting.

2. Amount Owed – 30% of your credit score

The second most important contributor to your credit score is the amount you owe as a percentage of the total credit extended to you (ugh algebra). This metric is commonly referred to as your “credit utilization” and is calculated as:

Total Balance Across All Credit Cards / Total Credit Limit

Let’s say I have 2 credit cards, each with a $5,000 credit limit. I currently have a balance of $1,500 on the first card and $500 on the second card. I would calculate my credit utilization like this:

($1,500 + $500) / ($5,000 + $5,000)

($2,000) / ($10,000)

=20%

In this scenario, my utilization ratio is 20%. Try to keep your utilization below 25-30% (but still greater than 0%) to illustrate that you can responsibly manage your credit lines without overextending yourself.

3. Length of Credit History – 15% of your score

A longer credit history is better for your score since it gives lenders more insight into your borrowing habits. If you have an old credit card with no annual fee, keep it open to boost the average age of your credit history. If you’re a newbie to credit cards, it’s important to start establishing a history. The agencies need to have at least 6 months of data on an undisputed account to generate a score for you.

4. New Credit – 10% of your score

New credit inquiries impact 10% of your credit score. Each time you apply for a new card or loan, the issuer will make a “hard inquiry” into your credit history, which dings your score. Many people believe you should be overly cautious when opening a new credit card because of this. While you shouldn’t get carried away and apply for multiple cards in a short period of time, this concern is over-exaggerated for a few reasons:

  1. Hard inquiries fall off of your credit report after 12 months.
  2. New credit inquiries only contribute to 10% of your score, so the impact is minimal.
  3. If you pay the new card on time each month, it helps your Payment History, which is the largest contributor to your score (scroll up to number 1 for a refresher).
  4. Opening a new card increases your available credit, which decreases your utilization. And as we know from number 2, your credit utilization is the second largest contributor to your credit score.

The important takeaway here is that even though a new hard inquiry may temporarily lower your credit score by a few points, the net long-term impact to your score is positive when you open a new credit card (assuming you pay it off every month). Just make sure it's the right credit card for your lifestyle and spending habits.

5. Types of Credit – 10% of your score

The last 10% of your credit score comes from the various types of credit extended to you, or your credit mix. Creditors like to see that you can manage multiple credit cards or loans, so having a good mix of retail accounts, credit cards, mortgages, or car loans is a good thing. However, this is the least important factor comprising your score. It is not necessary to have all of these types of loans in order to achieve a solid score.

How do you check your credit score?

Several credit card issuers offer their cardholders free access to their credit score, including American Express, Barclaycard, Chase, Citi, Capital One and Discover, among others. It’s important to note that your score may differ slightly if you check it in different places. This is because different issuers may pull your score on different dates or based on credit reports from different bureaus.

Everyone is entitled to review his or her credit report for free once a year with each of the three credit bureaus. This is a great way to check whether you have any adverse transactions or disputed accounts in your credit history. In fact, I recommend you check all of your credit reports every year to ensure that there are no mistakes and to file disputes if there are. Visit AnnualCreditReport.com to request your free credit reports.

The Bottom Line

I keep my credit score on the same pedestal as my social security number, BFF’s phone number, and Uber rating. It’s THAT important! You might understand credit scores in the context of applying for a new credit card. But it is so much more pervasive. Let’s say you’re in the market for a new home. Having a good credit score can meaningfully impact the interest rate your bank charges you. Now let’s say you bought (or leased) a car and are purchasing insurance on it. Your rate will also be based on your credit. Landlords, utility companies, and even cell phone companies can require security deposits based on your credit score. It’s everywhere! So it’s important to (1) know it, and (2) know how to increase it. Learning the 5 factors that comprise your credit score will help you do just that.

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