Credit

The content contained on or made available through this website is not intended to and does not constitute as legal or investment advice. Please use and refer to the information at your own risk, and consult with a professional before making any finance-related decisions. Refer to the full Terms & Conditions here. Last updated January 1st, 2020.

Takeaways

  1. Understand the factors that determine your credit score

  2. Begin building a credit history as soon as possible

  3. Utilize options available to those that are just starting out

  4. Ideally target a 740+ credit score

  5. Always pay your credit card balance in full each month

 

Healthy credit is essential to a bright financial future. It is required to be eligible for loans, avoid certain deposits and collateral payments, and qualify for lower interest rates on a mortgage. “Credit scores” are the numerical representation of your creditworthiness (i.e. how much risk does an institution take on by lending to you?).

 

How is your credit score calculated? In short, traditional credit scores are produced through an algorithm created and maintained by Fair, Isaac, and Company (FICO). FICO gathers information from the three credit bureaus (Experian, Transunion, and Equifax), which in turn gather information on your payment history. This is then used to calculate a score ranging from 300 (worst possible) to 850 (perfect).

 

Each credit bureau collects information differently; therefore, you may be assigned different credit scores depending on the source of information. Furthermore, FICO has the capability to calculate different versions of your credit score depending on whether you are looking for a mortgage, auto loan, credit card approval, etc.

 

Since FICO’s algorithm is proprietary, it is impossible to directly calculate your own credit score. However, FICO has provided a general outline of the key factors that they use in their calculations. They are broken down as follows:

  • Payment History (35%)

    • Do you have any missed payments? Do you pay credit card balances in full, or just the minimum? In order to receive the highest score for this category, always pay your credit card balance in full after you receive your monthly statement and never miss a payment. A single missed payment will ding your credit score and remain on your credit report for 7 years. The same goes for payments on installment loans (e.g. car lease, mortgage, etc.).

 

  • Amounts Owed (30%)

    • What percentage of your credit limit do you currently utilize as a running balance? For instance, if you have $1,000 in payments due and a $10,000 credit limit, this equates to 10% utilization. As a rule of thumb: the lower the utilization the better (ideally between 1% - 9%). Utilization above 30% represents a material risk to lenders. Unlike other components of your credit score, utilization is viewed as a snapshot in time. That is to say, utilization in one period does not impact your credit score in the next.

    • While not quite as transparent, FICO also considers the original amount of any installment loans vs. their current balances. It is more difficult to act on this piece of the equation, so making on-time payments and keeping loan balances low is your best bet.

    • The last piece of Amounts Owed is the number of accounts you own with active balances. Maintaining multiple accounts with on-time payments is a sign of a responsible borrower.

 

  • Length of Credit History (15%)

    • The three main pieces to this are: age of your oldest account, age of your newest account, and the average age of accounts. Essentially, the longer you have owned various lines of credit, the better. Because of this, you can expect a temporary dip in credit score whenever opening a new line of credit.

 

  • Types of Credit Used (10%)

    • The mix of accounts you own, such as revolving credit (e.g. credit cards) and installment loans (e.g. car payments), also impacts your credit score. Ideally, you will have multiple accounts with varying attributes.

 

  • New Credit (10%)

    • When you apply for a loan or a new credit card, the company responsible for the transaction will run a “hard check” on your credit. The more hard checks on your credit within the last 12-24 months, the more it appears to be “credit seeking” activity. In moderation, this is ok. However, excessive credit seeking is a sign that you may pose a higher risk to those that lend you money, thus reducing your credit score.

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When you first become financially independent, it can be fairly counterintuitive how one starts to build credit. For instance, a credit card application may be denied by the major companies due to a lack of credit history. But how are you supposed to build credit history without a credit card in the first place? Below are a few ways to get started:

 

  • Student friendly credit card companies: Certain companies (such as Discover and Capital One) are willing to take a “risk” on students without a credit history. The credit limit will be quite low, but this is a great way to begin building credit right out of the gate.

 

  • Secured credit cards: A credit card with collateral. When you open a secured credit card (which you can typically do regardless of credit history), you will put forth a down payment that (in most circumstances) is equal to your credit limit. This way, if you do not make a payment on time, the credit card company can simply use your collateral to pay the bill. Once the account is closed, your deposit will be returned. Used responsibly, a secured credit card is one way to begin building a credit history.

 

  • Find a co-signer: If you can find someone with strong credit to co-sign a credit application, your chances of being approved increase significantly. The co-signer, however, will be on the hook for any late or missed payments.

 

  • Authorized user: Becoming an authorized user (on your parent's credit card, for example) can be a great way to start building credit. This method is not fool-proof, however, as credit card companies do not always report authorized users to the three credit bureaus.

By whatever method necessary, begin to build credit as soon as possible. If and when you are eligible to receive a credit card, pay the balance in full each month without exception. A missed payment can ding your credit score for up to 7 years. No other factor in the development of your credit score is as impactful for this length of time.

​Conclusion

 

Having a strong credit score can seem trivial at first, but it may end up the difference between a 4% and 7% APR mortgage. And depending on the house’s value, this can add up to tens of thousands of dollars in interest payments.

 

A “good” credit score is in the range of 720 - 740+, while an “excellent” credit score is 800+. The important thing to note here is that you will be qualified for most prime interest rates with a “good” credit score. Beyond that, an “excellent” credit score will only benefit you in certain edge cases.

 

When it comes to building credit, the best advice is to start early. Open a credit card account as soon as you are able to, always pay in full, and never miss a payment. Doing so will prove to lenders that you are reliable and creditworthy.

The content contained on or made available through this website is not intended to and does not constitute as legal or investment advice. Please use and refer to the information at your own risk, and consult with a professional before making any finance-related decisions.

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