Check Yourself Before You Wreck Yourself: Understanding Your Credit Score

Knowing your actual credit score is straight forward. You can sign up for an app like Credit Karma and they'll give you your credit score. Alternatively, if you apply for a mortgage, the lender will run your credit and they may even tell you your credit score.

Getting your score isn't the problem. The elusiveness lies in understanding how your credit score is actually calculated. The exact formula used to calculate your credit score is like Coca Cola's secret recipe; it's not public information. What we do know is the calculation consists of five different elements and the weight or level of impact each elements has.

The categories and their weighted impact are payment history (35%), credit utilization (30%), length of credit history (15%), new credit (10%) and type of credit used (10%).

It's weird that we don't have the exact formula for calculating our credit scores. It's kind of like taking a class where you're expected to do all the work to get a grade and you understand how the work can impact your grade, but you don't know exactly how your grade is calculated. 

Yeah, it's fucked up, but if you want to participate in the economy and use credit, you have to play the game.

 

Payment History

Your payment history is a record of how you've handled paying back money that you've borrowed. When you borrow money for a student loan or through a credit card company, each month the lender you borrowed from reports your payment history to a credit bureau. There are three major credit bureaus in the U.S. The big three are Experian, TransUnion and Equifax.

Quick History: Why are there three national credit bureaus?

Here in the U.S., national credit bureau companies have the most clout. Back in the day, before the big three, there were many smaller companies. The smaller companies were regional companies, each one only serving their respective markets in the West, Midwest, South and East. Overtime, the big three began to scoop up and acquire smaller credit reporting agencies. Eventually, they gobbled up enough smaller companies that covered all the territories that they became national.

Even though the big three are the major players, dozens of smaller, specialty credit reporting agencies still exist for different markets.

The big three report differently because some companies may report credit activity to only one bureau. Some companies may report to all three, but the data could appear different simply due to the fact that the data is compiled at different times.

 

When Does a Late Payment Get Reported?

Usually the company you are borrowing money from only reports your credit payment history every 30 days. That means if you're two days late on a credit card payment, it's more than likely that you'll get a late fee, but your credit score will not be negatively impacted until you're 30 days late. If you miss your payment two months in a row or for 60 days, you'll get reported twice: once for being 30 days late and then again for being 60 days late.

Since approximately 35% of your credit score is made up of your payment history, missing even one payment can have a huge impact. The impact is also long lasting. Missing payments stay on your credit history for 6 years. But the upside is, once you start making your minimum payments regularly, over time it impacts your score less and less.

 

Credit Utilization Ratio

Your utilization ratio is how much of your total available credit you’re using. Sometimes it's also called debt utilization ratio. Here's how you calculate it: 

The total balance ÷ Your total available credit = your credit utilization ratio

Let's imagine your credit card limit is $1,000 and your balance is $300, your utilization ratio is 0.3 or 30%. A utilization ratio of up to 33% has a positive impact on your credit score. Every percentage above 33% will negatively impact your score.

Since credit bureaus are in the business of grading you based on your behavior with credit, it makes sense that the amount of credit you have has an impact on your score.  If you max out your credit cards or regularly maintain a high utilization ratio, it could be the symptom of a larger problem: your income is not enough to keep up with making your payments. This makes you less desirable to lend money to, which translates as a lower credit score.

 

Length of Credit History

The longer you have a good credit history, the better. Two people who have never been late on a payment aren't comparable if you don't consider the length of time. Someone who has never been late over the course of twenty or thirty years seems like a safer bet than someone who has never been late for only one year. Consistency is key. 

 

New Credit

Financial constraints can cause people to apply for credit more often than those who aren't as strapped for cash.  So each time you apply for credit, your score gets dinged a bit.

But if you're shopping around for a mortgage or car loan, don't sweat the inquiries too much. The bureaus will see what's happening and your score should recover once the shopping process is complete and you've locked in a loan.

 

Type of Credit Used

Not all credit is created equal. Loans that have fixed terms: a fixed payment, over a fixed period, at a fixed rate for a fixed amount is better than a credit card. Fixed loans usually have a lower interest rate than credit cards and if you make all your payments on time, you'll pay it off.

A credit card is called revolving debt. It's revolving because it doesn't have anything fixed. The rates can change according to the terms. The terms can change according to the credit card company. The amount you borrow can change if you charge more purchases. If you never make more than minimum due and continue to charge each month, you can get stuck in credit card debt for the foreseeable future.

 

Don't Get Too Caught Up

It's important to give a few fucks about your personal credit score because it has a real impact on your life. You might have your credit pulled when you apply to rent an apartment and you'll certainly have your credit score pulled when you are borrowing money for a mortgage, a car loan or if your business is still too new to have a credit history.

But don't obsess over it. If you've screwed up, don't beat yourself up over it. Focus your efforts on taking the steps necessary to improve your score. It's easy to get caught up in the score because, well, it's a score. A score can be compared to other scores and it's not as immeasurable as other things, like how awesome your creative pursuits are or how much your spouse loves you. If you start to get too weirdly obsessed, remember that it's just a tool for our silly modern world.