Credit score: what it is, how it works, and why it doesn’t necessarily matter for you

Yes, I did choose that intentionally provocative title. I see a lot of questions from people that don’t seem to understand what a credit score is, what it’s really used for and not used for, and why they should worry about it. So let me explain here a basic version of credit reporting and who actually needs to worry about it. If it’s too long, scroll to the bottom where I talk about what actions you can actually take to help your credit score.

Who needs this information

  • Anyone who has or plans to have any credit cards
  • Anyone who has or will have loans: student loans, auto loans, medical debt
  • Almost anyone planning to rent a living space – it’s common for housing managers to check credit scores to evaluate how likely you are to pay rent on time.
  • Almost anyone who plans to get a mortgage -most mortgage lenders use automated forms that require a FICO score at minimum. If you live with no debt in your life, you will have to look for a lender that will do manual underwriting. And you must be absolutely on top of all your bills, have an have healthy balances in both your checking and savings accounts. They all matter for manual underwriting.

If you are just starting out and on a mission to have no debt at all in your life, I talk about that in another post. Also, you don’t need this information, because if you have no credit history, you don’t need to know how credit reports and scores work.

Credit Reports: Start here

Before we talk about credit scores, we should talk about credit reports. This is because, you can’t have a credit score without a credit report. To dive into the full detail of what a credit report is, use this page from the Consumer Finance Protection Bureau, which breaks it down into detail while still being very easy to understand. (By the way, the CFPB is a government agency charged with ensuring that borrowers are treated fairly by their lenders. They have a lot of info about different kinds of borrowing and how it all works.)

What does a Credit Report Track, and who maintains them?

  • Personal information, including name, address, and date of birth
  • Debts, including credit cards, auto loans, student loans, mortgages medical debt, and personal loans
  • Public records, including property liens and foreclosures, and bankruptcies
  • In a brief overview, your credit report tracks your personal information (like name, address, date of birth), your debts (like credit cards, auto loans, mortgages, or student loans), and any public records (negative information like liens, foreclosures, or bankruptcies.)
  • There are three different companies out there whose business is creating credit reports for every person who has credit: Equifax, TransUnion, and Experian.

How long do items remain on your credit report?

  • Your personal information is always in the report, although it won’t always be up to date
  • All currently open debt, debt that is still in active repayment, delinquency, or collections will be on the report for the duration of the repayment.
  • Paid off debt remains on the report for 7 years after repayment is complete
  • Public records will remain on the report for 7 years after they are resolved
    • There is one public records exception: Chapter 7 bankruptcies remain on a credit report for 10 years after bankruptcy is granted.

Checking Credit reports and clearing up inaccurate information

The federal government mandates that all three credit reporting companies allow individuals to view their report once a year at no cost. The website for this free annual check up is annualcreditreport.com. You don’t have to check all three reports at the same time. Spread them out throughout the year if you like, but check them every year, especially if you’re looking for a housing rental, auto loan, or mortgage that year. Different lenders use different credit scores, and those credit scores may use all or any of these reports. That’s why it’s important to check them every year.

You can not change negative information about you on the report, like an accurate report that you are delinquent on a debt.

You can dispute inaccurate information, like an incorrect address or loan status. For example, let’s say you have fully paid off a loan, the lender has changed it from ‘in repayment’ to ‘paid in full,’ but your credit report shows it’s still in repayment. That can be disputed because it is inaccurate.

If you find inaccurate information on a report, you first should contact the company to ask them to correct it. The companies are required to do this “in a timely manner – within 30 business days,” but they often won’t.

If the company hasn’t updated your inaccurate information in 30 business days, use this guide from the Federal Trade Commission to dispute it. The FTC is the government branch responsible for monitoring the credit agencies, and the agency you appeal to if the companies don’t clear off the info in a timely manner. If you think the companies have not cleared the info fast enough after you have notified the FTC, you can lodge a complaint against them.

Credit Scores: Your report in a number

The information in your credit report is used to create your credit score, which is also called your FICO Score. FICO stands for Fair Issac Corporation, the company that develops and maintains the score. There are actually many variations of FICO scores depending on which credit reporting agency is used and what kind of loan you are applying for, but they all follow one general model.

Payment History (35% of score)

The biggest part of your report is your payment history. Simply put, do you pay all your bills on time and in full? If you pay your bills late or don’t fully pay them, this hurts your score. This is also where things like foreclosures and bankruptcies go.

Credit scores are concerned mainly with your debt accounts, but staying up to date on things like utilities is also important when applying for money even though it’s not part of your score. If you are delinquent on utilities, this does get reported to credit bureaus. Delinquencies on utilities are treated like debts because you owe money to the utility companies.

Because payment history is the single largest part of your credit score, it is EXTREMELY important to talk to your lenders if you are having trouble making your payments. Let them know you are struggling but still committed to paying off what you owe, and ask if there is an alternate payment plan that can be used to structure your repayment and lower the amount. This will often extend the duration of the debt, but it’s better than being delinquent and dinging your score.

Amounts Owed (30% of score)

There are several sub-components to this section. I’ll talk about them quickly, but you can get more information from the MyFICO site.

  • How much do you owe overall?
  • How much is owed on different types of accounts? (Like credit cards, vs car loans, vs mortgages, vs student loans)
  • How much do you owe on each specific account?
  • How many accounts have balances? (Remember, paid in full loans still stay on your report for 7 years after they are repaid. Having a blend of open and closed accounts on your report shows you can pay off your debts and looks very good)
  • How much of an installment loan is paid off compared to its original balance? (Installment loans are ones you pay down over time and eventually pay off. Revolving debts are things like credit cards that are used and paid over and over.)
  • What is your credit utilization rate on all revolving debt, and in each account?
    • This one is going to take a little explanation. You’re credit utilization rate is how much credit on your credit cards you are using compared to how much you can use. It’s expressed as a percentage and 15% or below is the sweet spot.

Credit Utilization Rate: An Example

Let’s say you have 3 credit cards. You have a $2,000 credit limit on Card A, with a $500 balance. You have a $2,000 credit limit on Card B, with a $150 balance, and you have a $5,000 credit limit with Card C, and a $1000 balance.

The first level that utilization is applied at is per card. To find it, divide the amount you owe on each card by the total credit line available on the card. So Card A has a 25% utilization rate, Card B has a 7.5% utilization rate, and Card C has a 20% interest rate. As I said above, the sweet spot on credit utilization is 15%, that’s for each card as well as overall.

So how much do we pay off in each card? Multiply your credit limit by 0.15 and subtract that from what you owe. The difference is what you have to pay off. So for Card A we need to pay off at least $200, Card B is fine, and Card C needs a total of $250 paid off.

Utilization is also assessed as a whole, combining all the cards. In this case, we add up all the owed balances, and then add up all the credit limits. Divide the owed balances by the credit limits and you get your total utilization: ~18.33%. But, by paying off each card down to 15% utilization or lower, our total utilization would also be 15% or lower. After all, it’s just the average among the cards. If the utilization on each card is 15% or less, then the average will also be 15% or less.

Length of credit History (15% of score)

This seems like it would be one simple calculation, but it’s not. A few of the different things that go into this is the age of each individual account, their average age, how often they are used. For example, if you have 2 credit cards and one is 5 years old and the other is 1 year old, both of these pieces of info matter, as does their average age, which is 3 years old. If you don’t use one of those credit cards every month, that also matters. How long have you had your student loans, or mortgage? That’s the kind of info covered here. There’s not much you can do to manipulate these numbers. They just go up as time passes.

Credit Mix (10%)

How many different types of credit do you have? This operates on a few different levels. YOU DO NOT NEED ALL TYPES FOR A GOOD CREDIT MIX SCORE! Some examples are:

  • How many revolving accounts do you have compared to installment accounts?
  • What is the mix of your installment accounts?
    • For example, maybe you have a mix of a car loan, student loans, and a mortgage.
  • What is the mix of your revolving debt?
    • Mainly the difference here is general credit cards from a bank vs. specific cards from a specific store, like Sears.

New Credit (10%)

The best thing for your score is to add new sources of credit slowly if you add them at all. Don’t apply for 3 credit cards and a car loan in the same year. (0-2 new accounts is best, depending on exactly what they are.) If you plan to have more than 1 credit card, spread getting them out over a span of years. If you’re going to get a mortgage, don’t buy an expensive car the same year if you’re financing it.

In Conclusion

As you can see, a lot of information is used to make a credit score. The best actions you can take as an individual to help your credit score are:

  • Keep a budget and build up some savings. That makes a lot of the following actions easier to take.
  • Always keep up with your bills, both debt-related and non-debt related. If you’re having trouble keeping up with loan payments of any kind, talk to your lender and be honest with why you’re having trouble. You can work out alternate ways to pay.
  • Even if you are in the habit of paying off your credit cards in full every month, limit the total amount of spending you are putting on your cards in a month to maintain a good credit utilization. Ideally stay at 15% credit utilization or lower. (This is especially important in the 6-12 months before you get a mortgage. If you’re using a lot of your available credit every month, even if you pay it off, it can look risky in that situation.)
  • Check your credit reports annually at annualcreditreport.com and follow FTC procedures for filing a dispute with the agencies and lodging a formal consumer complaint if you need to.
  • Space out new credit accounts. The two exceptions to this are for mortgages and student loans. As long as you keep all your mortgage shopping within a 2-week window, your FICO score won’t be hugely affected.. (That’s because FICO knows you aren’t going to take on 5 mortgages simultaneously. You’re comparing them to take out one mortgage at the best terms.) And for student loans, it’s natural to build them up over the course of school and then enter repayment afterwards, so this won’t have a big impact on your score, even if you get several new individual loans per year. But limit yourself to 1 credit card in college, if any.
  • If you are carrying a lot of debt, make a plan to pay it down or off. The more debt you have, the harder it is to borrow more if you need to. Again, this is most relevant with a mortgage because mortgages are for such a large amount of money compared to most others. I talk about using the Avalanche/Snowball method to get out of debt in this post.

This all condenses down to a simple message: manage your money well, keep your credit reports accurate, and let your credit score take care of itself.