A lot of people do not know about the Fair Isaac Corporation but may have heard about the term FICO Score. Well, The Fair Isaac Corporation was founded in 1956 and created the FICO Score which is maybe one of the most influential numbers you will track and follow for the rest of your life, as it dictates a lot about what life you will lead. It essentially is one number that represents your credit worthiness and will determine what credit cards you qualify for, car loans, and probably most importantly, your mortgage rate. The score ranges from 300 – 850 and is rated in these brackets:
While the inner workings of the FICO scoring system are a closely guarded secret, the Fair Isaac Corporation has opened up about the five general components of a FICO credit score and how much influence each component has on the wrapped FICO score. Over time, we have been able to kind of dissect the FICO credit score and break it down. Here are the general guidelines to follow and how to build your credit score and game the system.
1. Payment History - by far the most important component of your credit score as it makes up 35% of your overall credit score.
FICO monitors your revolving loans (credit cards), and installment loans (mortgages, student loans, car loans), and takes into consideration the frequency, recency, and severity of reported missed payments. Therefore, the MOST IMPORTANT thing you can do to get to or keep a good credit score is to NEVER MISS A PAYMENT. This means do not take on debt you cannot service and always pay your credit cards in full and on time. A lot of credit cards now offer auto-pay functionality connected with your bank account. While in general I like this feature and use it myself, there are potential downsides that I will cover later in this blog post.
2. Credit Utilization – is the percentage of available credit that has been borrowed and makes up 30% of your overall credit score.
If you own a credit card and max it out every month, odds are you are not using your money wisely – and FICO knows this. According to FICO, the people with the best scores tend to have a credit utilization ratio of less than 6%. In general, you should never really be exceeding 20% utilization of your limit but should still use your credit cards to some capacity to build viewable credit history.
To increase your score in this category, you can do two things:
3. Length of Credit History – is a simple average of the length of time each credit account has been open and makes up 15% of your overall credit score.
Here is where the importance of starting early really makes a difference. I remember being in high school and getting my first credit card with a paltry 1% back on purchases. However, that account is now my oldest credit account of about 4 years. See the trick here is that the length of credit history category is calculated as a simple average, and to maximize the score in this category, you have to start early and have a lot of accounts.
To explain, here is an example:
Sally has 5 credit cards and has an average length of credit history of 3 years.
Tom has only 1 credit card that he got 3 years ago so he also has an average length of credit history of 3 years.
However, to progress on their financial journey and in search of better credit cards with better bonuses/rewards both Sally and Tom decide to get a new credit card.
With the addition of a new credit card Sally now has 6 credit cards and since her new card has an age of 0, her average length of credit history falls to 2.5 years.
Tom now has 2 credit cards but since he only had one card to begin with, his average length of credit history falls from 3 years to 1.5 years.
The difference here is massive, Tom just took a huge hit to his credit score, while Sally experienced a much more muted effect. This effect is further diluted as Sally gets more cards. If she had say 10 cards at 3 years, by adding a new card her average length of credit history would have only fallen to 2.73 years. For this reason it is beneficial to load up on credit cards early (and responsibly!) and make sure you get cards that have no annual fee because most cannot really effectively use all 10 cards to the point that it is worth paying the annual fee. Also, make sure you use each card once every two years (I set a recurring reminder in my phone every year just to be safe) so that an old card does not get cancelled.
By getting more cards now, you dilute the negative effect of future cards. If you are younger or in college, you can afford to take the dings to your credit score now to build your future credit score in preparation for arguably your most important financing arrangement – a mortgage. However, to qualify for a mortgage you usually need at least two years of pay history and if you want a low rate you need to have an excellent credit score (above 740). In the meantime, if you do not have your stable full time job yet I would suggest you start building your credit as early as possible. I only wish I knew this much when I was 18. If you have a kid, I would teach them this information from an early age and also look into my best piece of advice, especially for youngsters, opening an IRA.
4. New Credit – has more influence on your total FICO credit score than older credit and makes up 10% of your overall credit score.
This category really goes hand in hand with #3, length of credit history. In short, new credit account activity is a better indicator of your current financial health, thus is weighted more heavily. However, as stated above, adding new accounts decreases your average length of credit history. Also, opening up too many new credit accounts in rapid succession may suggest you are in financial trouble and need significant access to lots of credit. As a rule of thumb, if you are older and have significant expenses, you should be slow to open new accounts. While having some new credit bolsters your score, the effect is offset by the dings you receive from the hard inquiry and lowered average length of credit history. In general, hard inquiries stay on your credit report for about two years so as some fall off you may feel more comfortable getting new credit. However, if you are younger, you probably don’t need an excellent credit score and should feel more comfortable loading up on more cards, although credit card approval algorithms do often take into account average credit age history, total open accounts, and hard inquiries. If you start getting denied for new credit cards even though you have an excellent credit score, it might be time to slow down on the credit card churning.
5. Credit Mix – is essentially having a variety of credit accounts and makes up 10% of your overall credit score.
Basically, the idea behind this category is being able to handle and repay a variety of credit products means there is less risk to any given lender as according to FICO, historical data indicates that borrowers with a good mix of revolving credit and installment loans generally represent less risk for lenders. This means that having a combination of auto loans, mortgages, student loans, and credit cards helps your credit score. To caveat, credit mix is a small percentage of your overall score. I would not delay paying off high interest student loans or car payments if I had the ability to (and was not getting the interest written off my taxes) just to bolster my credit score a point or two.
In addition, here are a few major factors that affect the 5 categories and little tips to optimize them:
Hard Inquiries – the number of times you have applied for credit.
Has a low overall impact but should still be avoided if unnecessary as it shows your credit is often being questioned or you are often in need of additional credit. The good thing is these drop off of your credit report about every 2 years so do not worry too much about them in the long term.
Total Accounts – the total number of open and closed accounts.
Generally, like credit mix, you want to have more total accounts as it shows you can handle a lot of different credit accounts and therefore different creditors. You should aim to have more than 10 total accounts to improve your credit score.
Derogatory Marks – are collections, tax liens, bankruptcies, or civil judgments on your report.
These have potentially the highest impact on your credit score. If you declare bankruptcy no creditor will want to touch you with a ten-foot-pole no matter how good your credit score may be. Avoid putting yourself in a situation with debt collectors as they can eventually report you and dramatically hurt your credit score. You should dispute a collection if you have any good reason and try to negotiate and pay down your debt if possible.
Public records like bankruptcies, civil judgments, and tax liens are harder to remove. If anything is seemingly wrong gather records, build a case, and dispute with the credit bureaus to remove the public record. You really do not realize how important it is to have access to credit to move up in life until the ability is gone.
Lastly, I would strongly encourage you to constantly keep up with your credit score. You are legally entitled to a copy of your credit score once a year from each of the big three credit bureaus – Experian, Equifax, and TransUnion. However, to be honest I have never gotten a paper copy. I keep track of my credit score using CreditKarma.com. This is not a plug, I honestly think it is really interesting to see how my credit score is moving and what has changed month over month. I check CreditKarma probably 3-4 times a month to get a pulse on my financial health and make sure I am not making any wrong moves. Plus they send me emails updating me when something changes which is super helpful.
With this knowledge under your belt, I wish you the best you finance warriors.