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

If you have or plan to have debt and loans in your life, you need to care about your credit report, with one exception I’ll get to shortly. If you already have a credit card or student loans, then you have credit and this information is important to you. If you are planning to get credit cards or apply for a car loan, personal loan or other type of borrowing, this information is important for you.

One exception can be your mortgage. If the only debt you plan to have in your life is a mortgage – because not everyone can realistically save enough to pay for a house in cash quickly enough – then you might not need this information. You can still get a mortgage without a credit history, but you will need to borrow from a bank that does full underwriting. (Ask about this before you apply, as many banks use an automated form that depends on a FICO score.) Make sure you always pay your bills on time and have a healthy balance in both savings and checking accounts, because these matter. Actually that bit matters for everyone, FICO score or no. If you want to look into how to get a mortgage with no credit history, also known as “non-traditional credit history,” this page at NerdWallet explains how that can work.

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.)

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.

Information on your credit report (aside from personal info) stays on your report for a fixed time after the event. Almost everything will clear from your report in 7 years. For debts, that means 7 years from the date they were paid in full. For public records it means 7 years after the date of the record. There is one exception: Chapter 7 bankruptcy, also known as “liquidation bankruptcy,” is cleared from your report after 10 years.

You can and should check your credit reports every year. You can’t change negative information on them, but you can have inaccurate information cleared. For example, let’s say a public record was created on your credit report for a foreclosure in error. (This does happen sometimes, especially if names get confused.) You can tell the credit bureaus to take it off. You are entitled by law (in the US) to one free copy of your credit report from each of the 3 companies every year. Don’t go to the companies’ sites for these reports. The official site for getting your free reports every year is annualcreditreport.com.

If you do find something inaccurate, 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. The companies will investigate the information based on the information you provide, and if it is proved inaccurate, they are required to remove it. Legally that should be within 30 days, but reality is that it can take months to get this info removed, because the departments responsible for doing this within the companies are often under-staffed. If you think the companies have not cleared the info fast enough, you can lodge a complaint against them with the FTC.

Note: Different lenders use different companies to check your credit. They don’t have to use all 3 and they usually don’t tell you which they use unless you think to ask them. That’s why it’s important to check all 3 reports every year.

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.

This is why I always stress talking to your lenders if you are struggling to make your payments. Talk to them as early as possible, and work out a plan. For example, if you have trouble managing your student loan payments every month, talk to your lender about a longer payment schedule. While that does cost more interest overall, it lowers your monthly payments so you can pay them in full every month. Talk to your lender before something drastic happens, like getting so behind that the company calls in debt collectors. They are willing to work with people to make their debt repayments work for all parties – you and them.

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?
    • 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.
    • 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.
    • Add up all the balance on your cards. Total: $1,650
    • Next, add up all your credit limits. Total: $9,000
    • Divide your total balances by your total credit limit and you have your credit utilization rate. In this example, it’s ~18%.
    • If you are over 15% and want to pay off enough of your cards to get down to 15%, multiply your total credit limit by 0.15. Then subtract that number from what you currently owe. The difference is how much you would have to pay off. In this example, we’d have to pay off $300 to bring us down to 15% credit utilization ($1,350.)
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 shopping around within a 2-week window, your FICO score won’t be hugely affected by shopping around for the best mortgage. (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.

So manage your money well, keep your credit reports accurate and let your credit score take care of itself.