If you’ve been reading our blog, then you might have read my short and sweet explanation of a credit score, possibly the most important aspect of finance in the league. On a side note, this article is NOT short or sweet. It’s longer than usual, so I hope you don’t get bored.
As mentioned earlier, it is essentially a gauge of your financial standing with personal debt, income, and history with debt.
Well, I left a whole lot of questions on the table completely unanswered. If you’re a quick learner, then you know what I am getting at. Now, I want to talk about what exactly factors in to your credit score. So… what determines your credit score?
There are actually a couple of different theories behind this question, but they all are similar to some degree. For the sake of simplicity and consistency, I’m going to refer to the FICO score. Just know that there are other answers out there, but they do not differ much from this one.
So without further delay, I present to you the five metrics that factor in to your credit score. Here they are:
Credit Utilization Ratio – 30 percent
Numerically speaking, it may be second in terms of importance, but it’s pretty damn important, making it a priority. Unsurprisingly, the total amount of debt you owe factors into your credit score considerably, but there’s a bit more to it than a lot of debt or a little bit of debt.
More specifically, this refers to the magnitude of debt compared to your overall credit limit; these two establish a ratio known as a credit utilization ratio. Needless to say, if you owe as much or more than your current credit limit, then it is viewed negatively. If you owe next to zero percent of your credit limit, then raters may not know how to score your credit. You want to fall somewhere in between.
The established, ideal benchmark for a solid credit utilization ratio is around 30, 35, or 40 percent. Some sources will peg this benchmark at either of these or other numbers, but it’s around this ball park. Example time: if you have a credit limit of $1,000, then a 30 percent utilization ratio involves $300 in debt.
Keep in mind that having a higher or lower ratio than the benchmark is not a death sentence. Statistically speaking, it’s just a good idea to keep you credit utilization ratio sort of in the middle because it shows that you have experience handling debt, but it also shows that you won’t spend and run out on your debt obligations like a crazy person.
Payment History – 35 percent
Payment history is numerically the most impactful factor of a credit score, and it’s pretty easy to understand. In a nut shell, it’s an overall gauge of whether you are great at paying back debt on time
Credit monitors will look at your history of making payments, and they will record how many of these payments were made on time or missed completely. Additionally, if a payment is late, then they will record how many days late. Furthermore, they will record if you’ve gone bankrupt, settled debt in the past, or anything else resulting from a failed debt obligation. These are known as red marks or red flags.
So, if you want to game this one, it’s fairly simple. Pay your debt obligations before they are due. If there are no red flags on your credit history, then it’s smooth sailing for this metric.
Duration of Credit History – 15 percent
This one is decently important, and it can be either extremely hurtful or helpful depending on your payment history. If you have a long, successful credit history, then this will work in your favor. If you have a super short credit history, then this is somewhat of a non-factor which I don’t like. For those who don’t have the luxury of a clean slate, it impacts your credit rating negatively.
While this category sits by itself, I’ve never been a fan of it because people who have short credit histories can still get approved for certain products which would supposedly devalue this metric. On the other end, those with a long credit history can either be supremely rewarded or royally screwed over. Why shouldn’t a credit score metric be all encompassing and apply across the board to all credit builders equally?
My main argument is this metric is too dependent on the payment history metric since it makes or breaks its impact. I don’t like that it is dependent on time. I like to look at payment history overall as a 50 percent weighted metric, but that’s just an opinion.
Recently Opened Credit – 10 percent
This one is pretty fair and simple. Credit monitors will look at your recent activity in terms of opening up new lines of credit. If you’ve been opening credit card accounts like crazy and applying for like eight different mortgages, then a private student loan lender is going to tell you to get lost. If you’re taking on a ton of debt, you look like a risk factor which is reflected in your credit score.
If you’ve opened up a few lines of credit that make sense given your recent finances, income, and assets, then you’re looked at as responsible. Just don’t go crazy with credit applications, and you should ace this one.
Forms of Credit – 10 percent
Last is the forms of credit factor. This metric takes into account the number of accounts you have open such as credit cards, student debt, or mortgages, and it gauges that mix as a factor into your credit score. What is a good mix? Not a crazy one. Well, that is not helpful, but it’s a pretty small factor. Generally speaking, if I had to guess, I would say that if you have just one form of credit, then it’s not a super, healthy mix? You tell me.