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Credit Scores and What Really Affects Them

Posted 23 February, 2012 at 11:51am by Michael Chu
(Filed under: Credit Cards, Life)

Over the years, I've heard a lot of different theories about how to increase your credit score. Most of them are grounded in some truth, but are based on incomplete knowledge. For example, a lot of people say that given the choice to buy a car with cash or finance it, you should finance the car to build credit. Although, that is generally true over time (in the short term, the auto loan will actually hurt most credit scores), there are often better ways to increase one's credit score without the initial negative effects and without having to pay real money on interest.

A credit score, such as the FICO score (produced by the Fair Isaac Corporation), is a numerical way for banks and lenders to determine if an individual is a credit risk. The scores generally range from 300 to 850 depending on which company and which method is being used to calculate the score. In theory, an individual with a 300 on this scale would be someone who would definitely default while an individual with a score of 850 would be guaranteed to not default. Since nothing is ever certain, the scores are designed so people will fall between these two extremes.

The algorithm used to calculate the scores vary from lender to lender, but most follow a similar model to the one used by Fair Isaac. Of course, the details of this model are kept secret and may even change over time, but, over the years, how the credit score is calculated in general has been made public. Some factors serve to increase credit scores while other factors decrease them. Keep in mind, that to a bank, an unknown to them can be just as risky as someone who overtly exhibits bad behavior. They use what data they have to determine how well you manage both credit and debt. An individual without any debt can be just as risky to a lender as an individual that sometimes has trouble managing their debt. The least risk comes from people who have a history of being "trusted" with credit and have managed it well (used only a small portion and are never late on payments) and have a variety of different types of debt (for example, a loan such as a mortgage and credit cards).

What affects the credit score?

    High Effect:

  • Percentage of On Time Payments
    Accounting for over a third of the credit score calculation, this is the number one way to keep a high credit score or to lower it. It's best (almost imperative) to keep the percentage of on time payments at 100%. Even one missed or late payment can drop this percentage to 99%. On average, people who have 99% on time payments have credit scores 50 points lower than those with 100% on time payments.
  • Revolving Credit Utilization Percentage
    This is the second most important factor when calculating credit scores. Your revolving credit utilization percentage is basically the amount of debt you currently have on your credit cards divided by the sum of all your credit card limits. For example, if you have 3 credit cards with $3,000, $5,000, and $7,000 limits respectively, then you have a total credit card limit of $15,000. If you have a combined balance of $4,000 on all the credit cards, then you would have a revolving credit utilization of 26.7% (4000/15000=0.267). Note, that even if you pay off your credit cards every month, the amount that you use during that month prior to paying it off counts towards revolving credit utilization. If you don't use your credit cards at all, your revolving credit utilization would be 0%. It's best to use less than 20% of your total credit limit (in this example, use less than $3,000) but more than 0%. Creditors prefer to provide credit to those people who use credit responsibly than to people who don't use credit at all. An individual who doesn't use credit is risky because the zero utilization doesn't demonstrate restraint; it just shows the person doesn't use credit cards. The worst scenario is not having any credit at all. On average, people who have less than 20% utilization have 35 more points than people who use 20-40% of their credit limit. People who use less than 20% of their credit limit also score, on average, 75 points higher and 170 points higher than people who have 0% utilization and people who have no credit at all, respectively. Obviously, when starting out, people will not have any credit history, but, soon after receiving your first credit card, credit scores will drastically improve.
  • Negative Information (aka Derogatory Information or Remarks)
    Derogatory Remarks on one's credit report do not factor into the credit score in the same way that on time payments and credit utilization do. They only serve to lower credit scores, and there is very little that can be done to improve the situation except to wait until they clear which can take up to 15 years in some cases (although many derogatory remarks clear within 7 years). Examples of derogatory remarks are collections, liens, or anything in the public record like court ordered settlements, child support, or alimony. Paying settlements or child support on time and regularly does not increase credit scores.
    Moderate Effect:

  • Length of Credit History
    It is estimated that the length of credit history accounts for 15% of your credit score. There are a couple of factors that are included in this "history". The most notable is the average age of open credit lines. More than 8 years of average open credit lines is best. There's not much one can do to improve this part of the score except to wait. For example, if you had three credit cards opened in January 2004, 2006, and 2007, then, in January 2010, the average age would be 4.3 years. In January 2012, the average age would be 6.3 years. However, if during this time the credit card opened in 2004 had been cancelled, then, in January 2012, the average age would only be 5.5 years. Cancelling one of the more recent cards could actually improve the average age. Cancelling the 2006 card would result in an average age of 6.5 years while closing the 2007 card would result in an average age of 7 years. In general, it's best to not close older cards because they help keep your average age older. In fact, the most detrimental thing one can do to affect average age of open credit lines is to cancel your oldest card. (When cancelling cards, this is usually the card that credit card companies will suggest because it typically has the lowest limit because it was applied for and issued when the individual's credit history was youngest. However, it's not a good idea to cancel the oldest card as it tends to have the largest affect on average age.) Opening new credit cards will also reduce the average age of open credit lines, but generally the increase in total credit (and subsequent decrease in utilization percentage) as well as the increase in total number of accounts (discussed below) will result in a net increase in credit score even if average age decreases slightly.
    Another (smaller) factor in determining length of credit history is the oldest credit line. Typically, credit score algorithms look at the oldest credit line regardless of open or closed status, but some algorithms will use both oldest open and oldest closed age as part of the score. There is nothing that can be done to improve this part of the score except to wait / grow older.
    Low Effect:

  • Total number of accounts
    It might be hard to believe at first, but the more accounts you have the better. From a creditor or lender's point of view, this makes sense. If other creditors have extended credit in the past and other lenders have loaned money to this individual and there are no derogatory remarks, then this individual is more likely to not default on future loans or fail to make payments or misuse additional lines of credit. Having over 20 accounts listed in the credit report (of any type: open or closed, revolving/credit card or installment loan, etc.) is best for one's credit score. In general, each additional account will increase the credit score by a few points. After more than 22 different accounts have been accumulated, having more accounts does not affect this part of the score (neither postively nor negatively).
  • Types of credit
    Although credit scores are heavily based on credit card (revolving credit) usage, scores can be boosted if the individual is shown to have a history of managing different types of credit. Aside from revolving credit, installment credit is the other main credit type that can provide an increase in this portion of the credit score (which is the portion that has the least affect on credit scores). The most common types of installment credit (also referred to as installment loans) are auto/vehicle loans and mortgages. It is this factor, that causes many people to provide the advice of taking a loan for the purposes of increasing credit scores. However, type of credit is such a small portion of the credit score that if you've built a solid credit card history, there should be no reason to pay interest on installment loans for the purpose of increasing or keeping a high credit score. It is my advice that if you do not need to take a loan, that you shouldn't do it to increase your credit score. Even if you are just out of school and buying your first used car and do not have credit history, if you don't need to take that auto loan, you shouldn't do it to build credit history. You're much better off getting an entry level credit card, using that card slightly every month, paying it off on time, and soon your credit score will jump up as time passes.
  • Number of Hard Inquiries
    All credit report inquires are reported on your credit report, but only "hard" inquiries affect credit scores. Hard inquiries are "normal" inquiries by creditors or lenders made when applying for a new credit card or loan. The inquiries stay on the credit report for two years, and, generally, multiple hard inquiries in a short period of time (like those made by multiple loan companies when you shop for an auto loan or mortgage) are combined into one inquiry when counted for the credit score. Any hard inquiry is considered a negative, but, in most cases, the impact of a hard inquiry is offset by the credit extended. For example, to apply for a credit card, the credit card company will request a credit report which results in a hard inquiry. If they approve a new credit card, then the increase in total credit, decrease in percentage utilization, and increase in number of accounts usually more than offsets the hit from the hard inquiry (usually resulting in an increase in credit score).
    No Effect:

  • Soft Inquiries
    These are inquires performed by the individual (checking your own credit reports or using a monitoring program) or employer checks for employee verification. They are present on the credit report, but have no effect on the credit score.
    Variable Effect:

  • Loans
    More than one mortgage is usually a negative. Auto loans are usually a negative initially, but over time they can become positives (due to number of on time payments, contributing to different types of credit, and counting as an additional account).
    Paying some loans off early (like auto loans) can have a negative affect, so if you have a loan, it's generally best to keep it if the interest is very low (otherwise interest savings is probably worth more than a few points since as months pass your score should be increasing as credit card age increases). In most cases, paying off a loan early is probably best in the long run for your overall financial health and taking a short term credit score drop (which in the majority of cases will be very small) should not affect your decision to pay off the loan.

Notice that credit scores are not affected positively or negatively if you keep a balance on your credit cards (i.e., you do not pay off your credit card in full each month). There is a common belief that if you leave a balance and pay the minimum (and thus maximum interest over time), your credit score will increase. (The rationale being that creditors use the credit score to see how much money they can make off of an individual.) This is not true. The credit score is designed to help creditors predict an individual's chance of defaulting. Individuals who make regular payments (either in full or carrying a balance) are considered equivalently trustworthy.

Another common misconception is that you need to keep using the credit cards you have. This stems from an incomplete understanding of how credit utilization affects credit scores. If you have only one credit card, then you should make sure there are charges on the card every month, but if you have multiple cards, then it isn't necessary to continue to use an older card that you are keeping around to increase your average account age. All that you need to do is make sure you have some credit utilization each month to prevent the 0% credit line utilization scenario.

Hopefully, this post helped explain credit scores. One last thing to keep in mind is that the credit score is just one of the factors that a bank, lendor, or creditor uses when deciding on extending credit or a loan (or loan rate). How much a bank will give in terms of credit is dependent on multiple factors including the credit score, previous history with credit lines, income (not money in the bank - cashflow is what they care about), total debt, and debt to income ratio.

1 comment to Credit Scores and What Really Affects Them

Shelley, February 23rd, 2012 at 4:53 pm:

  • Thanks for breaking down a very complex process. I thought I was pretty familiar with how scores are calculated but I learned a thing or two from your post. By all means, keep these types of posts coming. If you have any notes on asset allocation, fund expense ratios, etc. for retirement planning, I'm eagerly awaiting that post. It seems like it requires a degree in finance these days to make sounds decisions on investments. As a science major, I get baffled with all the jargon.