What’s In a Credit Score?

Credit scores – a necessary evil.  Credit scores are used for everything from approving someone for a loan, to making someone a job offer. People with higher credit scores get lower interest rates, lower insurance rates, and more job offers.

The question I hear most often from people is, “How do credit scores work?”. Well, good question. Some of what you believe may be good for your credit may actually hurt your credit score. So, here’s my attempt to “demystify” credit scores.

The first step in understanding credit scores is to understand how a credit score is calculated. A credit score is made up of the following:

1. Payment history – 35% – Paying bills on time is the largest factor in a credit score.
2. Amount of debt – 30%  – The amount of an individual’s credit limit they’ve used, also known as credit utilization, accounts for the second highest part of a credit score. If an individual’s cards are maxed out, his/her credit score will suffer.
3. Length of an individual’s credit history -15%
4. Inquiries -10% – Applying for new accounts can actually lower a credit score, unless the inquiries are related to shopping for a car loan or mortgage.
5. Mix of credit – 10% – This looks at how many different types of credit an individual has, i.e. mortgage, car loan, credit cards, personal loan, etc. The more different types of credit, the better for a credit score.

As you can see, the biggest factor in a credit score is that individual’s history of paying bills on time.

Now that we’ve seen how a credit score is calculated, let’s look at some myths associated with credit scores, and things you shouldn’t do in an attempt to improve your score.

1. Don’t close old accounts. This may seem counter intuitive, but don’t close old accounts, even if they’re not being used. Closing them can hurt your score, because it negatively impacts length of credit history.
2. You can remove negative information just by disputing it. WRONG! This is one of the biggest scams out there, and responsible for the rise of the “credit repair” industry (to be discussed in a future post). Negative information that is accurate and true, such as late payments, collections, etc.  cannot be removed from your credit report.
3. Credit card solicitations and offers hurt your score. Wrong. If you don’t respond to the offers and use up all the new credit, they don’t hurt your score.
4. Checking your own credit will hurt your score. Wrong. Applying for new credit can hurt your score due to the inquiry made when you do so (unless you are shopping for a mortgage or car loan), but you checking your own score doesn’t count as a negative inquiry.
5. A bankruptcy will destroy your credit score for 7-10 years. Wrong. A bankruptcy often substantially improves your credit score because it updates the reporting of late payments and eliminates your debt load.

A credit score is an important tool in your financial toolbox. If you understand it and maintain it, it will save you thousands of dollars in interest and fees over your lifetime.

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