I wanted to take a minute and give you a quick overview of what the Credit Bureaus really look at when they calculate your credit score since we’ve primarily gone over tips and strategies to improve your score so far.
Realize that this is just an outline of guidelines they claim to use and that access to the actual algorithm they run each credit file through to produce a score is known by few people on earth. And even if they know about it doesn’t necessarily mean they understand it or can explain exactly how it works, too!
Also, it helps to know that the WHOLE reason the credit scoring system was created was to help creditors calculate what your chance of defaulting on a loan given to you would be.
With that in mind, here’s the overview of what they look at:
1. Your Payment History: This supposedly accounts for 35% of your total credit score. This is related to whether you pay your creditors on time or if you have been late (30 days or more that is).
They factor in details such as how many accounts you have that are late, how long it’s been since you made a late payment, number of items that are past due and if there are any adverse public records like bankruptcy, judgments, liens, etc.
This is why being 30 days late on even one account can cause your score to drop so much, up to 100 points in cases I’ve seen. Payment History is the crux of the whole system since creditors only care about your ability and track record of paying others on time.
2. Balances Owed: The amount of debt and ratio of that debt to your credit limits accounts for 30% of your total credit score. This is a tricky one, because it’s not simply tied to how much debt you have, because I’ve seen people with millions of dollars of debt across
mortgages, credit lines and car loans and have a credit score over 750 and I’ve seen people with a $400 credit card that’s maxed out and a score of 510.
What matters here is really what the balances are on the accounts compared to their limits, which brings us all the way back to the #1 way to increase your credit score… Keep your balances below 50% of the limit on your revolving accounts (credit cards and lines
of credit.)
When you think about it, this makes complete sense. You don’t want to be penalized for buying property and having a mortgage since that has the potential to add to your wealth, and everyone in our society needs a car to get to work, so you can’t be penalized for
that debt either. So all that’s left is credit cards and lines of credit.
Since they’re unsecured, the more of it you have, the greater the risk of the creditor from not getting paid back, through Bankruptcy and unpaid collections. Over time the bureaus saw a correlation between high balances on revolving accounts and increased rates
of default on those accounts and others the borrowers had. So they ended up with a formula that factors this in and is now 30% of your credit score.
3. Your Length of Credit History: This is simply related to how long you have had credit accounts and the age of your oldest active account and it accounts for 15% of your credit score.
Notice I said this factor is also tied into the age of your oldest active account and how that ties back into one of the Myths I blew up in the first email I sent you. The last thing you want to do is close a credit card account that you paid off and is the oldest active account you have. I recommend keeping the 2nd oldest active credit card account open as backup in case the oldest one gets shut down for any number of reasons.
The credit bureaus made a change to their calculation of length of credit history in August of 2007 because there was a loophole that many people were exploiting up until that point. All someone needed to do was to be put on a credit card account as an ‘Authorized User’
and they would instantly inherit all of the good history from that account on their report as if it was theirs from day one.
It was a great way for parents to help their kids establish credit early on in life and was a big factor in my wife having a near 800 credit score when we got married when she was only 24. Credit repair scam artists also used this to build new credit for those with bad
credit by having them placed on accounts of the elderly who had
very long history that was perfect.
It worked like a charm and the scam artists were charging a lot to do this since it was the only way they could think of to get someones credit repaired and perfected. It is now obviously an ineffective method for helping someone’s credit score and is hopefully putting many scam artists out of business.
4. New Credit: This accounts for 10% of your credit score and is tied to the number of recently opened accounts and their type. This is why your credit score typically drops after you get a new credit card, buy another home or finance a new or used car. They want to make sure you handle every new account properly and pay it on time before they reward you for it.
This is also the section of the scoring model that factors in credit inquiries by creditors you apply for credit from.
Unfortunately there’s no hard and fast rules about inquiries and how much they affect your score when you get them, but there are some rules of thumb you can follow.
First, the more inquiries you have, the more desperate you look to creditors and lenders since those with perfect credit typically work with one lender and have everything taken care of by them and they get the best rate possible at the lowest price. If you’re shopping around and having everyone pull your credit, it looks as though your fishing for anyone that will bite and approve your request.
Next, the weaker your credit report is, the more you will be affected by credit inquiries. Think of your credit score like a bridge, the deeper the footings are laid (like a long history) and the stronger the material the bridge is made of (like low balances and on time payments), the more weight it can handle and a credit inquiry is much like a canary coming to sit on the bridge. If your bridge is rickety (short history) and made of wood and rope (late payments and collections) and you’ve got a big truck (maxed out accounts) driving across it and then the canary comes and lands on the truck, it is possible that everything could fall apart and your score could go down quite a bit. How much? I have no idea.
Just realize that the urban legend of your score going down 3 points every time your credit report is pulled is simply that, an urban legend we all need to let die.
5. Types of Credit Used: This accounts for the final 10% of your credit score and is based on whether you have installment loans like mortgages, car loans or student loans, and if you have revolving accounts like credit cards and lines of credit.
Think of installment loans as the footings and foundations of your bridge and revolving accounts like the cables holding it all together.
Obviously you need both, but they are treated quite differently.
Installment loans are stable, typically secured against some type of asset and are treated as such with little fluctuation in your credit score for having them. Even though they don’t affect your score wildly (unless of course you pay one 30 days late or more!), they give your credit file stability that is very valuable.
Revolving accounts are unstable, unsecured, fluctuate wildly and affect your credit score significantly on a month to month basis. That’s why the #1 strategy for getting and keeping a high credit score is to keep your revolving account balances below 50% of their
limit.
It’s these revolving accounts that gives you a really high score and are necessary for having near 800 credit scores. The installment accounts are just not given as much weight to get you up that high.
It makes sense, too. It’s the revolving accounts that take more responsibility to manage properly and with more responsibility comes more reward and is true across every part of life, not just credit.
*Hint: That’s why I will forever be an entrepreneur.
