NOTE: This is part 2 of a series on Demystifying Credit. For part one, click here.

In Shakespeare’s day he asked “What’s in a name?” but if he were here today, he might ask, “What’s in a number?” In fact, many people have asked that question about credit scores. As mentioned in Part 1, credit scores are used widely by anyone from insurance agents to lenders to hiring managers. Because your credit score can impact so many aspects of your life, it’s important to understand so you can make informed choices for you and your family.

In our last post we explored how to access and understand your credit report (the information used to calculate your credit score). Today we’ll help you make sense of your credit score, understand what things impact it, and what you can do to either improve or maintain it.

Why do I have multiple scores?

Credit scores are the result of complex mathematical calculations used to simplify the information in your credit report into a 3 digit number to make comparison easy among a group of people. If you’ve used an app to track your credit score, you may wonder why the score provided in the app was different than the score your bank or credit card company retrieved in the application process. The differences in scores are the result of three main things:

  1. Different Information: As discussed in Part 1 there are 3 companies (Equifax, Transunion, and Experian) that provide your credit history data and sometimes the information provided is slightly different among them. When different information is used in the calculation, it follows that the scores will also be different.
  2. Different Scoring Companies: There are multiple credit score methodologies and various companies that produce credit scores; each has its own formulas. The two primary companies that provide credit scores are VantageScore and FICO. While Vantage scores are often used by credit score tracking apps, FICO scores are more widely used by lenders during the loan application process.
  3. Different Purposes: Lenders look for different things depending on the reason for the application. For example, buying a car vs buying a house. A house purchase requires a much bigger loan than a car purchase and comes with a longer time to pay back the loan. Because of the differences, lenders consider certain criteria more heavily, which leads to a slightly different score calculation.

When you combine these 3 aspects, the result is dozens of possible combinations so rather than having just 1 credit score you actually have many different score possibilities depending on the lender and which formula they have decided to use in reviewing applications. However, all these different credit scoring formulas operate off the same primary factors. This means you can have confidence that the same core behaviors will help all of your scores improve over time.

How is my credit score calculated?

There are five core factors that are used to calculate your credit score. Since the FICO score is most widely used by lenders, we’ll discuss these factors from most to least significant based on their model (the same factors and improvement tips will apply to VantageScore but there are some small differences in the order of importance).

  • Payment History – Lenders like to see a consistent track record of making payments to creditors as it indicates you are likely to pay them as well. Your payment history includes the number and frequency of late payments, how long a payment was late (i.e., 30, 60, 90 days) before you got caught up, and accounts that were closed or sent to collections because they weren’t paid as agreed.
  • Amounts Owed – Lenders want to see that you aren’t overextended as that can lead to difficulty paying your debts. This factor includes total balances on all accounts and utilization rate (credit balances divided by credit limit) for revolving accounts such as credit cards. It’s important to know the balance reported is generally the amount from your last statement – even if you paid the entire balance when it came due. (Note: This also means you do NOT need to carry a balance on your credit card to help your score.)
  • Length of Credit – While it is entirely possible to have a good credit score with short credit history, the lender has less information on which to base their decision. Length of credit considers the average length of accounts and age of your oldest and newest accounts.
  • New credit – While taking a new loan is not a problem, opening multiple accounts could indicate a financial hardship or other problem and therefore an increased likelihood of difficulty paying back a loan.
  • Credit Mix – Managing different types of credit (credit cards, mortgage, car loans, etc.) shows you can manage different accounts simultaneously. It is not necessary to have every type of credit but some diversity is positive.

Top Tips to Improve Your Credit Score

  1. Make on-time payments: From a credit score standpoint, this should be your top priority even if you have negative marks like collection accounts (once there, the damage is already done – avoiding current/future missteps is more important as time will heal the old wounds).
    • Get organized. Know what you have coming in and going out and arrange your finances so you have money available as bills come due.
    • Payment reminders (through account settings, a calendar app or paper calendar), and automatic payments (if funds are reliable) can both help avoid missed payments.
    • If you ever get into a tight spot do everything you can to avoid a payment reaching 30 days late as that is when it will show up on your credit report and impact your credit score.
  2. Keep Balances Low: This mostly pertains to revolving accounts like credit cards. You want to keep your balances below 30% and preferably below 10% of your available limit. This is one of the quickest ways to improve your credit score if you have the means to lower that ratio to the desired range now. Otherwise, working toward it gradually will lead to a steady increase in your score.
    • Pay down your balances – Not only will this help your credit score but will also keep your money in your pocket by reducing interest payments.
    • Be careful with low limit cards – Remember that your statement balance is what is generally reported so you may have to use the card sparingly or make extra payments during the month, including just before the statement comes out, to keep that balance low.
    • Ask for an increase to your credit limit (AND don’t use it) – Be careful with this! The last thing you want is to rack up more debt and make your debt situation worse just for a short term bump to your score.
  3. Other: Tips 1 and 2 are the most critical for everyone. If you’re already doing those you can focus on other areas such as:
    • Minimize the number of credit requests you make – too many within 1-2 years can lower your score.
    • Consider keeping your longest lines of credit given that credit history is a factor in your score.

As you focus on improving and maintaining a high credit score, remember it is better approached as a marathon than a sprint. To circle back to my story from part 1, some dips in the score are short lived so don’t panic, just keep doing the right things. In my case, my score recovered within about 3 months time. If you’re seeking to improve your credit, it can take some time but if you remember the things that impact your score and are consistently doing the things outlined here, time will take care of the rest.

Thomas