What goes into a credit score?

Still watching the Olympics.

Look, I am not trying to be dramatic, but I feel like this is the 1960s space race compressed into two weeks every two years. Just like the space race, I have zero ability to help the USA win, I am here only for moral support, and I believe this highlights the wild world of geo-political competition fighting over bragging rights.

Your credit score rates your trustworthiness to borrow money. From poor (300) to excellent (850), this score tells lenders if they can trust you to pay them back. A better score increases your chances of getting approved for a loan and better rates. So what goes into this score?

The most commonly used model is the FICO score created by the Fair Isaac Corp. The FICO model uses five categories to rudely judge you and tell everyone about it.

Payment History (35%)

• The biggest category. Do you make your payments on time in the right amount? This is the most important category because it is the fundamental reason credit scores exist.

• How to improve: pay your credit cards off in full every month by the due date. If you buy ten Yankee Candles with a credit card and pay it off in full that month, boom, improved. Those Yankee Candles helped demonstrate how responsible you are. 

Amount Owed (30%)

• Also known as your credit utilization rate. This is a ratio of the amount you owe on your credit cards versus the amount of credit available to you (all the limits in your credit cards added together). You want to keep this below 30%. This tells a lender if you are pushing your limits every month. 

• How to improve: if your credit utilization is high because you haven’t opened a new credit card since you were in college or applied for a credit limit increase, consider opening a new card or requesting a limit increase. Only do this if you know you won’t increase your spending! This can be a slippery slope. If you need the credit limit low, keep it low. Overspending on credit cards is worse than a high credit utilization. 

Length of Credit History (15%)

• How long have you been borrowing money? If you can  say “back in my day, I used to pay my credit card bill by mailing a check,” you probably have a good credit history. Lenders can trust you because you know a thing or two because you’ve seen a thing or two. Just like Farmers Insurance. 

• How to improve: don’t close old cards. If you liked our previous credit card letters and want to switch to cash back cards, keep your other cards open. Pay them off in full then lock them up. This will keep your length of history growing.

Types of Credit (10%) 

• How many ways do you borrow money? Do you have a mortgage? Car loan? Credit cards? This mix helps lenders see you can borrow money for different reasons and not just to fuel a Yankee Candle and doughnut addiction with credit cards. 

• How to improve: nothing. If you don’t have a mortgage or car loan, please don’t get one to improve your credit. Borrow money only when you need it. If credit cards fit your spending habits, you probably already have them. 

New Credit (10%)

• Did you just open two credit cards and get a mortgage? You might be in what I am calling “the Target circle of doom.” I think Target calls it “circle week.” You now have all this blank space to fill with furniture, blankets, throw pillows, and aesthetically pleasing coffee table books. Guess what? You don’t need any of the coffee table books. Lenders know this, and now you’re a risk to lenders because statistically it takes 3 years for you to slow your spending on coffee table books and throw pillows. Lenders do not like to see a lot of new credit lines or loans opening at once.

• Personal experience: a few years ago when I was reading about credit utilization, I opened a new credit card and requested a limit increase for my other two existing cards. All this new credit caused my last card to deny my increase. Pretty embarrassing.

• How to improve: Patience, paying off your debt on time, and not opening a new card every time you get spam in the mail. Thankfully, new credit cards and loans don’t hurt your report for a long time. Paying off your new credit will quickly negate the hit your score takes.

There are three big controversies over credit scores:

1. The Bad Credit Circle: You raise your credit score by borrowing money and paying it back on time. If your credit score stinks, it costs you more to borrow money or prevents it entirely. This can create a difficult cycle to break: your credit score is low because you don’t borrow money - you don’t borrow money because your credit score is low. Factors that hurt your score like defaults, evictions, and bankruptcy take seven to ten years to fall off your report. Some argue this prevents people from recovering after a hardship. They are not wrong. Your credit score can prevent you from renting a new apartment closer to a better job or borrowing money to start a business. However, lending money is risky and can cost a lender a lot of money if you default. What would be a better way to assess someone's risk when borrowing money?

2. Paying rent does not improve your credit score, BUT getting evicted from a rented apartment hurts your score. Your landlord can sell the uncollected debt to a collection agency which will show up on your credit report. If failing to follow a rental contract can hurt your score, then successfully paying a rental contract should help. This seems like common sense. Just because a renter isn’t technically borrowing money, they are still legally obligated to follow a pay schedule. This is slowly changing, but it is not automatic. There are some services that will report your rent payments (for a fee) and credit cards that allow you to charge rent in a back door way to leverage paying rent to improve your score. Rent should be in your FICO score without needing to pay a fee or use a specific credit card.

3. The score goes from 300 to 850… who on earth made this scale? Why not 0 - 100? Or 0 - 1000? 300 to 850?? This makes no sense! Okay maybe this is just a controversy for me, but once we fix the other problems with credit scores, this will be next. This is my single issue vote. If Vice President Harris or former President Trump makes this policy announcement, they have my vote. 

Alright, enough about credit scores, it’s time to get back to the Olympics. I wonder which athlete has the best and worst credit score…

Call to Action

Make/Check your Experian credit report. If you don’t have one, Experian offers free credit reports! This is a super useful tool to ensure you aren’t the victim of identity theft or to check your likelihood of receiving a loan or credit card. 

If you aren’t planning on taking on a loan anytime soon, you can also freeze your credit to prevent creditors from meddling in your credit report and help reduce the risk of identity theft/credit card fraud.

What We’re Reading/Listening To:

Something helpful, hopefully

Debrief on Deck

Next week, Mike is going to talk about risk tolerance which might be unnecessary given the market down turn the past couple days… you’ve probably lived through your risk tolerance… now would be a good time to have your dog or child change your brokerage account password so you can’t check your account.

As always, please reach out to us with any questions or comments you have. You can reply directly to this email or find us on social media (X (formerly Twitter) and Instagram).

Until then, stay the course.

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