PERSONAL FINANCE

Understanding Credit: What It Is and How It Works

Wesley Jarmon, Engineering Project Manager

04 January 2017

Your credit score is a numerical value that is a summation of your total financial history. Think about that for a second: There is a calculated value out there tied directly to your name and social security number, that every bank and financial institution checks before they decide to do anything with you, or for you. This number tells everyone how suitable you are to be trusted with money. Even if it has no effect on your life today, if you plan on ever getting a mortgage, auto loan, personal loan, credit card, small business loan, or doing any business at all with a financial institution in the future, this numerical value will affect you.

The corporation that provides the most popular ‘industry standard’ for determining your credit score is called the ‘Fair Isaac Corporation’ and they calculate the ‘FICO credit score.’ There are other less popular scoring models besides FICO, which have slightly different equations for calculating your credit score. But since most of these scoring models are similar, in most cases improving your FICO score is all you need to worry about and the rest will follow. So for simplicity, let us focus right now just on how your FICO credit score is calculated.

Guard your credit.

Photograph by TheDigitalWay

Your FICO score is weighted into different sections. Your Payment History accounts for 35% of your FICO score. Your Amounts Owed accounts for 30% of your calculated score. Your Length of Credit History accounts for 15% of your score. And your New Credit and Credit Mix account for 10% each respectively, of your FICO score. Now let us look at these categories deeper.

Even if it has no effect on your life today, if you plan on ever getting a mortgage, auto loan, personal loan, credit card, small business loan, or doing any business at all with a financial institution in the future, this numerical value will affect you.

The most important variable which determines your FICO credit score is your ‘Payment History’. Lenders want to know if you have a history of paying your bills on time. They are also looking through your history to see if you have bankruptcies, foreclosures, lawsuits or anything else that illustrates potential problems with paying them back. This is the most important aspect of your credit score, so it is imperative you maintain (as much as possible) on time payments for everything you owe. A few late payments among many on time payments generally will not tank this category of your FICO score, but it is extremely important to minimize ‘hiccups’ here as much as possible.

Wallet full of credit cards.

Photograph by Stevepb

The next most important variable that controls your FICO score is your Amounts Owed. This area goes hand in hand with your Payment History. If you are consistently on time with your payments, you generally will have your amounts owed under control. There is nothing wrong with owing money. Amounts Owed becomes a problem when a pattern emerges where you constantly owe near your max allotment available – which is defined as your credit utilization. High credit utilization on revolving accounts is a huge problem, and silent killer, of many credit scores. A revolving account is an account where the balance does not have to be paid in full every month – the best example of this would be a credit card. Your FICO score is negatively impacted when your credit utilization averages too high. This means if you have a credit card with a $5,000 limit, and you are constantly maxing it out and having a $4,000 – $5,000 debt on the card, your FICO score is being hurt. It does not matter if you are making on time payments every month. Lenders do not want to give more money to someone who has the potential to have trouble making payments in the future because they constantly have a large amount of money/debt they owe.

The third most important metric for your FICO credit score is your length of credit history. This is one of the more simple categories to calculate and control. A longer credit history is a very good thing for lenders because they want to know that you have history and experience managing money and debt. Even if your credit history is poor (ie bad Payment History or Amount Owed) it matters and affects your credit score positively, that you do indeed have a history. If you have multiple lines of credit, your account’s age is averaged together, to get an average length of credit history. For this reason, it is strongly ill-advised to cancel or close revolving accounts. With those accounts closed, they hurt your length of credit history statistics. Unless there are fees associated with it, even if you are not using a credit card any more, do not close the account.

The last two categories here are your Credit Mix and your New Credit. Your credit mix affects your credit score because FICO takes into consideration the mix of credit which you have. It is advised that you want to diversify your credit. As an example, lenders want to see that you have experience managing a credit card, a car loan, and a mortgage, at the same time. Someone who only has a history with numerous credit cards would be seen poorly compared to someone who has a diverse history of different types of credit and has managed them successfully. New Credit can affect your credit score negatively when you are opening too many new accounts too fast. FICO has stated in the past that they believe opening several new credit accounts in a short period of time represents a greater risk of things not being paid. This risk is increased even more when the new accounts are in new areas of credit the person has no experience in, or someone who does not have a long history of credit.

Overall, mastery of these 5 areas: Payment History, Amounts Owed, Length of Credit History, Credit Mix and New Credit will allow you to maximize your credit score potential. This is not an overnight process. Many people (myself included) have spent years working to build our credit. So if you do not think you need a loan today for anything and this does not affect you, that’s fine, but when you do need a new car, or want to buy a new home, or need a small business loan in a couple years, it would be wise to have your Credit as “perfect” as you can. And that work starts today.

Wesley Jarmon

Wesley Jarmon

Author

Wesley Jarmon is an Engineering Project Manager at the Jet Propulsion Laboratory JPL/NASA.  He has built a career off of technical problem solving and developing new technologies.  Wesley recently moved from Bowie, MD and now lives in Los Angeles, CA with his wife.  In trying to build a life on the West Coast, establishing good credit and being smart with money has become a priority.  Wesley and his wife are actively working together to pay off all of their student loans, and are on track to be completely debt free by mid 2018.  They are also looking to become first time home owners by the end of 2018.

Comments

Get the Financial Intelligence for Wealth Building Ebook Free

You have Successfully Subscribed!

Pin It on Pinterest

Shares
Share This