Credit Score Black Box
Understanding how your credit score works so you can make informed financial decisions and reap the benefits of an excellent credit score.
Credit Score Black Box - Unlocking How Your FICO Score Works
For most of my life, I was aware of credit scores but it seemed like a black box that I did not know anything about. I was sent two Capital One cards in the mail and accepted the offers shortly after becoming an adult and then I ignored credit cards after that.
I understood that a higher credit score is better but that was about it. About four years ago I started looking into how it works. I was surprised that, when I explained how it works, most of the people I talked to did not really know how it worked either. Some of these people had purchased dozens of properties and had many credit cards and almost anyone would say were extremely well informed about how the financial system works.
Credit Score Basics
I am here to dispel the mystery to the black box that is your credit score. There are a few things to start with. First, your credit score is a number ranging from 300 to 850. A credit score above 700 is considered good but a score above about 720 will get you the best rates for most types of loans. A credit score in the mid to high 700’s all the way up to 850 should be your target. As you will see as we look at the components of your credit score, it’s only possible to have a “perfect” 850 credit score with a very specific profile of having many open credit lines that have been open for a long time and no recent new credit.
There are multiple types of credit scores. The one that nearly all banks use is the FICO score. There are other scoring models such as VantageScore but they are not used for lending decisions as far as I am aware. Many of the bank or credit card web sites that give you a free credit score are giving you a VantageScore rather than a FICO score. Some refer to VantageScore and others like it as a FAKO score since they are not very helpful and can be hundreds of points different than your true FICO score. A number of banks will give you one of your actual FICO scores but none give you all of your scores for free.
Now that we have established what type of credit score that is actually used, there is another variable. Within FICO scores, there are different version of the FICO score and also different versions tailored to specific types of loans. The majority of banks are currently using the FICO 8 score but some are using the newer FICO 9 score.
This is a good place to introduce the three credit bureaus who maintain your credit reports and calculate a FICO score. The three bureaus are Experian, Equifax, and TransUnion. It is a good idea to check your credit reports periodically because they can be different and can contain mistakes. I personally track my credit scores and reports two ways but both do cost money. I use Experian.com and also myFICO.com. You can sign up for free plans that give you a score once a month or something along those lines which is still quite helpful.
Although Capital One pulls all three credit reports when you apply for credit with them, the majority of banks pull only one credit report from one of the credit bureaus. What credit score they use can vary . Chase, for example, typically pulls the FICO 8 score from Experian at least for California.
I mentioned a credit pull here. This is also called a credit inquiry. When you apply for a credit product, it generally comes with a “credit pull.” This refers to receiving a copy of your credit report from one of the credit bureaus. There are actually two types of credit pulls. The first is a hard pull (or inquiry). This happens when you apply for credit and shows up on your credit report for two years. It factors into your credit score for one year. The second type of credit pull is a soft pull and this does not show up on your credit report. Most of the pre-qualification tools to see if you are pre-approved for a credit card typically use a soft pull to make that determination. If you decide to proceed with a full application, a hard pull is done. The terms and conditions usually spell out what type of credit pull is done. When only a soft pull is done, this is described as not showing up on your credit report. One exception to be aware of is that American Express typically does not give you further hard pulls once you have at least one personal card with them. Any additional cards you open with American Express are usually a soft pull but that is never guaranteed.
FICO Score Types
Within a FICO score version, there are also versions tailored to specific products. At Experian, I can see my FICO 8 score. There are also other versions available such as my FICO Auto Score 2 and FICO Auto Score 8. These two would be more likely to be used if you are buying a car. Likewise, there are FICO Bankcard Score 2, FICO Score 3, FICO Bankcard Score 8, and FICO Score 2. The first three would likely be used for applications for credit cards and FICO Score 2 is often used for mortgage applications.
Similar but slightly different versions of your FICO score exist for the other two credit bureaus as well. In my experience, most banks pull either Experian or TransUnion but Equifax can be pulled by some credit unions. Searching on the internet for a particular bank and what score they pull can be helpful if you are trying to minimize hard inquiries on one particular credit report or already have many on one bureau’s report.
Credit Score Components
Now that we have looked at some of the basics of your credit score, we can look at what actually makes up your credit score and how you can optimize your credit score. There are five components that make up your credit score. The components are payment history (35%), credit utilization (30%), length of credit history (15%), new credit (10%), and credit mix (10%).
Credit mix is the least important of the components and makes up just 10% of your score. This refers to the mix of different credit products you are using. Having credit cards, auto loans, mortgages, and other types of loans would give you a better score in this area. Except for the fact that you need to have some credit such as credit cards to have a credit score, I would completely ignore this component of your credit score. Especially, do not go out and get additional types of loans to improve this area.
New credit also only makes up 10% of your score. This component of your credit score is all about hard credit inquiries that are less than a year old. Although it is important not to have too many credit inquiries especially early on, once you have an established credit profile, this is not too important either. I have heard from people who have 40 or 50 inquiries in the last year but still have a very good credit score and can still be approved for credit cards. Having lots of inquiries does indicate “credit seeking behavior” and can certainly be a red flag for lenders. When you only have a few credit cards, a new credit inquiry will cause your credit score to drop a little bit but, as you have more credit history, the drop will only be a handful of points.
Length of credit history is another area that is difficult to do much about quickly but it does make up 15% of your credit score. There are two parts to this component of your credit score. The first is age of oldest account (AoOA). This is exactly what it sounds like. The first account that shows up on your credit report with be the start date for your AoOA. This part is generally referred to in years and months since that first account. The second part of length of credit history is average age of accounts (AAoA). Average age of accounts is also exactly what it sounds like. The years and months that make up how long each of your credit lines have been open are added together and divided by the number of accounts to find this number. If you only have one account, adding a second account will cut your AAoA in half. If you have twenty accounts and add a new one, the new account will only change your AAoA slightly. This is why it is important to open no annual fee credit cards early in your credit journey and not close them. These cards will keep your AAoA higher. As long as you charge something to each of those cards once every six months or maybe even one year, the lender will not close them for inactivity.
The last two areas are the most important and the ones to focus on because they make up 65% of your credit score put together. The first of these is sometimes called amounts owed or credit utilization and accounts for 30% of your credit score. This is the component of your credit score that you have the most immediate control over. Credit utilization is exactly what it sounds like and is calculated two ways. First, it is calculated for each of your credit cards individually. For example, if you have a credit card with a $10,000 credit line and owe $5,000 from purchases you have made, that equates to 50% credit utilization for that card ($10,000 / $5,000 = 50%). The second calculation is the total amount of credit you have available compared to how much is owed. For example, let’s say you have ten credit cards with a $5,000 credit limit for each card ($50,000 total) and you owe a total of $10,000 on all of those cards, that would be a 20% utilization. These two calculations as well as what types of credit lines (credit cards, mortgage, auto loan) are considered for how the credit utilization component of your credit score is calculated. Installment loans are treated differently than credit cards in terms of how the FICO score is calculated but the lower the utilization, the better. Another things to be aware of is that charge cards or hybrid cards as American Express now calls them, do not have a reported credit limit. This means that an American Express Gold, Green, or Platinum card does not report a credit limit and therefore cannot have a calculated credit utilization. Some scoring models do take the highest balance ever reported as your credit limit but this is unusual.
The final part of your credit score is your payment history which accounts for 35% of your credit score. This area is also one that takes a long time to change. Unfortunately, anything less than 100% perfect history of on-time payments on your report has a significant impact on your score. If you missed a payment for two months and it did report to your credit report, get current on your payments and avoid that mistake in the future. In about seven years, most items drop off your report anyway and you can have a clean report at that point.
Obviously, the more late payments and the later those payments are (30, 60, 90 days), the more this area will be impacted. Bankruptcies, collections, charge-offs, and other negative items will also bring your score down. If you have negative items on your report, you can overcome that and rebuild your credit. It will take some time but it goes by faster than you think.
Better Credit Score Fast
There is one way to make a big impact on your credit score in the short term. Four out of the five components of your credit score take a long time to change but one can be changed very quickly. This one area is your credit utilization and accounts for 30% of your score.
I recommend that everyone pay off their credit cards in full every month in order to avoid credit card interest which most often starts in the mid 20% range. If you are paying off your credit cards each month, the easiest way to improve your score right away is to pay those bills a few days before the credit card statement closes. This means that the statement closes with a much lower or maybe zero balance. For example, you have a credit card that has a $5,000 limit and you charge $3,000 to that card every month in expenses. If you wait for the statement to close at $3,000, you will have a 60% utilization. Optimal utilization is under 30% and, for the very best utilization, under 10%. If instead, you pay off $2800 of that $3000 you normally charge to the card just before the statement closes, you would have a $200 balance report on your statement which is only a 4% utilization. By only shifting your payment date to a few days before your credit card statement closes, you can drastically increase your credit score.
TL;DR
Your credit score should not be a black box that is incomprehensible. While the exact equations for calculating your FICO score are a closely guarded industry secret, you can take control of our credit score by paying attention to the five areas that make up your FICO score. Payment history (35%), credit utilization (30%), length of credit history (15%), new credit (10%), and credit mix (10%) can be optimized to improve your credit score which improves credit approvals and the interest rates you receive for those credit products. The number one way to improve your credit score quickly is to pay your credit card bills before the statement closes to give yourself the lowest utilization you can which also equates to the highest credit score. Also, open credit cards with no annual fees early on in your credit history and keep them open to make a solid platform for your length of credit history. Otherwise, pay your bills on time and be careful about too many new applications in a short period of time. Something like a new credit card every three months or once you receive the most recent credit card’s signup bonus (SUB) is a good rule of thumb. If you keep this up, you will have a credit score above 750 after a few years and easily have a credit score over 800 as you continue down your credit journey.