Explaining Credit Scores 101

Free Money Offers & Cheap Debt

It is suddenly ‘cool’ to make fun of credit scores. Big income earners talk down on credit scores as things only poor people need. No-Debtors call it ‘debt scores’ or ‘stay poor scores’ and brag about how they only pay cash so they don’t need a score.

Nonsense.

There is no reason to purposefully avoid having a good credit score.

We aren’t saying no-debtors are pants-wetters….but we aren’t not saying it

Not only are credit cards awesome (Free $$), but building and maintaining a high credit score is simple to do. Good credit should be a natural occurrence from how you live your life.

If you hate free money, hate low APR loans, and don’t understand opportunity costs so you want to save for years in a 0.1% savings account for all your purchases….you should stop reading now. Otherwise…

What is a Credit Score?

Credit scores are indicators of your risk that lenders can use to determine if they want to let you borrow money. The higher your credit score, the lower risk you are of defaulting on your loan, in theory.

You can think of your credit score as determining your creditworthiness, aka how likely you are to pay back your loans based on your history. The scores are calculated based on your ‘credit history’, which is a summary of a handful of activities like payment history, current levels of debt, and other factors.

The credit score is a number that ranges between 300 to 850, where the higher scores indicate higher creditworthiness.

The scores that are most important are the 3 major national credit bureaus: Experian, Equifax, and TransUnion (although there are many smaller bureaus).

The current credit score model and calculation was made by Fair Isaac Corporation (FICO). Other options are out there to calculate credit scores, but FICO is still the most widely used.

[F’er Note - many of the alternative methods we think are better as they put more weight on things that likely show a better chance to repay. For instance, if you don’t have a lot of credit history or a large outstanding amount of usable credit, but have a high income/wealth to debt ratio, you are likely a good person to lend to. But FICO puts no weight on your wealth or income.]

The other common consumer credit rating system is the VantageScore. The VantageScore was developed by the same top 3 credit bureaus as an alternative to FICO. The VantageScore uses “AI” (because what doesn’t use AI nowadays) and has been growing in popularity, but FICO is still used in over 90% of credit decisions.

What Does Your Credit Score Mean?

One of the most frustrating aspects of your credit score is the seemingly arbitrary numbering system. What does 300 to 850 mean? What is good? What is bad? what score should you shoot for? etc.

In general, you are considered to be:

• Excellent Risk = 800 to 850

• Very Good Risk = 740 to 799

• Good Risk = 670 to 739

• Fair Risk = 580 to 669 (nice)

• Poor Risk = 300 to 579

However, the worst thing you can be is N/A. If you don’t have enough of a credit history to get a score, you may have a harder time opening accounts than even someone with a fair or poor score.

In general, you need at least 1 account that has been opened for more than 6 months and reported to the credit bureaus.

[Note - Anecdotally, more than 0 people who followed the no-debtor or Dave Ramsey model were unable to get loans when needed. If you pay off all debt and avoid credit cards, you can be financially well off, but get denied for a loan or credit card.

We know at least one ‘I paid off my mortgage and have no debt’ guy who tried opening a credit card and got a $500 starting max limit. We know of others who couldn’t get credit cards at all. Yes, paying off a mortgage ultimately gets it removed from your credit report and can hurt your score long-term.

Keeping credit cards that you pay off every month is simple, and keeps a credit score so you have the option of easy debt if you need it.]

What Goes Into Calculating Your Credit Score?

Your FICO score is made up of 5 main factors, each is given a different weight:

• 35% Payment History

• 30% Credit Utilization

• 15% Credit History Length

• 10% Type of Credit

• 10% Credit Inquiries

We will explain each in more detail below. But the general takeaway is that having a long history of making payments, only using a small amount of the credit available to you, and if you haven’t been opening lots of new lines of credit recently, are the key actions the FICO score is trying to capture.

If you do those 3 things, you should have a very high credit score.

Also, these weightings can change person to person. For example, if you have a very short credit history, your credit payment history will likely get a lower weight in the formula since it is so short. The numbers above are typical for someone with a mature credit history.

Why A High Credit Score Matters?

There are a host of benefits to having a high credit score. Nearly every loan you apply for, the lender will pull your credit score. Having a high score, indicating you are a lower risk, will allow you to get lower rates on your debt (cheaper for you) and should allow for a higher limit that you can borrow.

Even if you aren’t opening credit cards to take advantage of the promotional points or if you don’t need an infinite 0% APR loan, your credit score is used for your mortgage and car loan rates.

[Note - If you are thinking of paying cash or paying down your mortgage/car loan fast, read about opportunity costs of doing so here. If you are wealthy already, it removes one expense and risk, but if you are trying to build wealth, paying off a 3.5% home loan is forgoing potentially higher returns on investments.]

We are big fans of using credit cards for nearly all your purchase. In general, you can get 1-6% cash back on your purchases from using credit cards. (We previously listed some of our standard favorite credit cards to use here along with the general ways we look to open and use cards.)

Having a high credit score, means you don’t have to do much work to churn cards for ‘free’ money. We typically get 1-4 offers a week from major credit card companies mailed to our home offering $100-300 in free money if we open up new cards.

Why Are There 3 Credit Bureaus?

Each credit bureau may have different scores calculated for you. The 3 credit bureaus are 3 independent organizations who are compiling public and private sources of information.

There are differences between the bureaus. For one, not all lenders report to all credit bureaus so some accounts may be missing from a bureau’s report. Additionally, each bureau has its own method of collecting and compiling the results. Lastly, there is some leeway in the calculation and each bureau may have slight difference in weightings.

Overall, the 3 scores should be relatively close.

Credit Score Categories

As previously stated there are 5 main categories that go into your credit score. The categories are compiled from nearly all common credit accounts:

• Mortgage loans & auto loans

• Credit cards

• Retail accounts (store credit & store cards)

• Other installment loans (any other debt you took out)

• Public information about bankruptcies, liens, etc.

These items are

1) Payment History 35%

Payment history shows if you have paid your accounts over time. If you have consistently paid all your accounts on time, your strong track record of payment is considered the strongest predictor of your likelihood to continue to pay your debts.

An occasional late payment won’t necessarily ruin your credit score, especially if you have a long payment history across many accounts. However, frequent late payments can start to add up.

But if you have bankruptcy, debt relief, wage garnishments or any non-payment, that is considered a much bigger red mark on your history.

Having payments that are long overdue or currently delinquent will have a larger impact than short missed payment times. And the longer in the past any adverse events were the lower weighting they will get.

2) Credit Utilization (Amounts Owed) 30%

Credit utilization is typically the least well understood part of the FICO score. You want a LOT of available credit. Owing a small amount is only marginally good on its own because you want a low credit usage compared to total available credit.

If 2 people both owe $1,000, but person A only has $10,000 available credit and person B has $100,000 available credit, then person B has a much lower credit utilization (10% vs 1%). Person B will have a higher score, all else being equal.

“You want a LOT of available credit and to utilize a small amount of it”

This is important. So we will quote from the myFICO site to drive this point home: “In a very general sense, Amounts owed refers to how much debt you carry in total. However, the amount of debt you have is not as significant to your credit score as your credit utilization. When a high percentage of a person's available credit is been used, this can indicate that a person is overextended, and is more likely to make late or missed payments”

We are credit card maxis here. We spent our early 20s churning credit cards for free promo money. Currently we have over 20 credit cards and well over $200k of available credit on those credit cards. Since we don’t carry balances, our credit utilization is <1%.

[Note - many cards require some activity or they get canceled. To simplify our life, we put a re-occurring purchase on older cards or have a card saved to different online stores we buy from regularly. For instance our utilities go on a card, our garbage on a different card, we use a food delivery service that goes on a 3rd card, amazon purchases a 4th, etc etc. This way we keep cards active without needing to track them.]

Not only does keeping older cards open help you maintain a low credit utilization, they also help with your length of credit history…

3) Length of Credit History 15%

You want a long credit history.

We try to NEVER close an account. As stated above, we keep a nominal purchase on all our old cards to keep them active so we can keep a long credit history. When you close an account, it will eventually be removed from your profile and you lose the benefit of the that card’s age in your average credit age.

Length of credit history takes into account your oldest account, newest account and the average age of all your accounts. Additionally, the length of time since you used accounts are taken into account.

[Note - If you have children, if you can open a joint credit card or get their name on an account, you can help them establish a credit history which will help them when they are young adults.]

4) Credit Mix 10%

FICO takes the mix of accounts into consideration for a small 10% weighting. Having a mix of different account types is viewed favorably. The general types of credit accounts are:

• Revolving Accounts: Flexible credit accounts that provide you a limit that you can spend up to. For example:

  • Credit cards

  • Retail store cards / gas station cards

  • Home Equity Lines of Credit (HELOCs)

• Installment Accounts: Fixed accounts that you pay down over time like:

  • Mortgage Loans

  • Auto Loans

  • Student Loans

Obviously, you shouldn’t go open a new student loan / auto loan / mortgage just to get an installment account for this 10% weighting. However, if you don’t have any revolving accounts, slowly opening a few credit cards or store cards may help with your score over the longer term. (Not to mention you get free money, cash back, fraud prevention, ease of tracking spending, etc…there really is no downside to responsible use of credit & store cards)

5) New Credit (10%)

Opening several accounts over a short period of time is an indication of greater risk. This is especially true of people with a short credit history.

When you open a new account, creditors will check your credit score. This credit check is called a ‘hard inquiry’ and hard inquiries are considered in your actual score. They will generally stay on your report for 2 years and impact your actual score for 1 year.

Similarly, if you opened a bunch of accounts recently, any new creditor may view that as you are in financial distress. It implies that you are taking on a lot of new debt and even if you have a high credit score otherwise, it can cause you to be denied.

[Note - Checking your own credit score never impacts your credit report. So if you use a service like credit karma, have free FICO score updates on your credit card statement, or get your annual free full credit report, none of those will impact your score.

Check your credit score for free here - this is the site to get your gov’t mandated annual credit score for free https://www.annualcreditreport.com/index.action

You should use one or more of these to ensure you didn’t get your identity stolen (ie - thieves are opening numerous accounts under your name) or that there is an error on your score (errors happen more often than is ideal, which would be 0).]

When you open a new account you will see a drop in your credit score, usually of a few points. This is due to both:

• The hard inquiry showing you are looking for more credit

• A new account which impacts your ‘newest’ and ‘average’ credit history

However, over the longer term, having more available credit will help lower your credit utilization rates and can help diversify your credit mix.

In general, we don’t worry about the small drop in credit score when opening a new account. Additionally, if you limit your new account opening to 1 account every 6 months or so you should avoid any issues with being denied.

Conclusion: Credit Scores 101

These are the basics to credit scores.

In an ideal world you are immensely wealthy and can opt out of the entire need for credit if you wanted to.

However, for most people they will still need (or want) to take out a loan for a new home, car, or to cosign on a loan for a child one day.

Imagine having historically low interest rates like we recently had and not being able to take out a 30-year mortgage at 2.75% fixed rate because you followed some ‘no-debtor’ advice and had a low or non-existent credit score…wouldn’t be me.

Also, it is easy to keep a high credit score with minimal effort. Getting and keeping a high score should be a by-product of your daily living and should not be a focus. If you had previously botched up your score from bankruptcies or delinquencies you may need a bit of focused effort to fix. But if you currently have a good score, you can likely coast and keep that score with no effort on your part.

We have 800+ credit and outside of seeing it on the dashboard for a few of our credit cards that offer free FICO scores, we don’t pay much attention to it. We also opportunistically open 1-3 cards a year just to get bonus cash. (However, at this point we have to close them out in order to be eligible again for opening a new card again in the future due to having most of the good rewards ones already. But if you have as many cards as we do, we assume you understand the credit card game enough and this post isn’t really for you).

So go check your score if you haven’t in a while.

A site like credit karma will show which of the 5 categories is dragging you down and you now know what you need to do to improve each area. Bump up that score and let the free money promos flow in while you wait for low rates to pounce on deals.