What Makes Up a Credit Score?

What makes up a credit score? The formula that creates your three-digit credit score is based on 22 different criteria. These 22 criteria, which interweave to create the intricate formula, can be categorized into five parts.

Part I: Your Payment History

Part II: Your Outstanding Debt

Part III: The Age of Your Credit 

Part IV: The Type of Credit You Have

Part V: The Number and Frequency of Your Credit Inquiries

What Makes Up a Credit Score? Part I: Your Payment History

Your payment history is the single most important part of your credit score. A full 35 percent of your credit score is determined by such factors as:

  • All payments for mortgages, loans (including installment loans and student loans), credit cards, and other revolving accounts (such as retail credit cards for department stores).
  • Late payments, including the frequency of late payments, the severity, and the recency. Late payments that occurred more than two years ago are less damaging than late payments that occurred within the last two years. And late payments within six months are the most damaging of all. Likewise, late payments that were 120 days past due are judged much more harshly than late payments that were 30 days past due. Having one or two late payments is not necessarily going to ruin your score if the rest of your credit report is solid.
  • Your payment history on mortgages, installment loans (such as car loans), revolving accounts (credit cards), student loans, and retail accounts (department store cards, gas cards, and the like).
  • The number of accounts that are in good standing.
  • The existence of collections, charge-offs, repossessions, bankruptcies, or foreclosures. These are among the most harmful activities to your credit score, though you can build your score to 720 if you learn how to fix credit.  In particular, if you have been through a bankruptcy or foreclosure, you can take simple steps to repair your credit score in as little as two years!

Always keep in mind that the credit-scoring bureaus pay more attention to recent behavior than past behavior. The credit-scoring models assume that your current behavior is much more indicative of your financial wellbeing than your past behavior. Keep in mind, as well, that most information falls off a credit score in seven years. The exceptions to this rule follow:

  • Chapter 10 bankruptcies fall off a credit report in 10 years.
  • Liens and judgments fall off a credit report 7 years after they are paid.

What Makes Up a Credit Score? Part II: Your Outstanding Debt

About 30 percent of your credit score is determined by the amount of money you owe creditors. This component takes a look at two things:

  1. The amount of money you owe on a loan compared to the amount you originally owed.
  2. Your utilization rate.

Let’s take a look at these factors.

Outstanding Debt Factor #1: The amount of money you owe compared to the amount you originally owed.

The credit-scoring models respond more favorably when you are invested in a loan. For this reason, new loans usually hurt your credit score. The damage is temporary your score will start to recover once you have made about six monthly payments.

The credit-scoring models know that you are less likely to default on a loan if you have money invested into the loan. Let’s say, for instance, that you have paid $19,000 of your $20,000 car loan. If your car will be paid in full in just three or four months, you are much less likely to default than someone who has paid only $1,000 of a $20,000 car loan. Ergo, the more you have paid, the higher your score.

Outstanding Debt Factor 2: Your utilization rate.

The credit-scoring bureaus take a look at the utilization rate on each credit card you carry. The utilization rate is the balance of your credit card expressed as a percentage of the limit. If you have a $700 balance on a credit card that has a $1000 limit, then that credit card has a 70 percent utilization rate. As you might guess, the credit-scoring models worry more about higher utilization rates than they do about lower utilization rates.

Ideally, you should try to keep your utilization rate at 30 percent or lower, month-round. Having a higher utilization rate tells the credit-scoring models that you might be overextended, and that you might make a late payment soon.

Keep in mind, too, that you should keep your utilization rate below 30 percent on each and every card, and that you should keep this balance month-round. When it comes to your credit score, you are far better off spreading your credit card debt among three to five credit cards, each with a 30 percent utilization rate, than you are consolidating all debt onto one low-interest credit card with a 90 percent utilization rate.

Please, please read about the dirty little credit scoring secret that results in an increased utilization rate that lowers your credit score!

What Makes Up a Credit Score? Part III: The Age of Your Credit

15 percent of your credit score is determined by the age of your accounts. Like wine, the older the better.

This component takes a look at both the age of individual accounts, as well as the average age of your accounts. In this way, each time you open a new account, the average age is lowered, and your score could drop. For instance, if you have three ten-year-old accounts, the average age of your accounts is ten years. But if you open another account, the average age drops to 7.5 years. As such, try to keep old accounts open. I recently decided to open a new credit card that offered a great rewards program. This credit card was intended to replace another rewards credit card that was inferior. That said, I kept the older credit card active, and I plan to keep paying the annual fee, because I know that my credit score is benefiting from the account’s age.

Remember from Part II that the credit-scoring models might deduct points if you open a new account. However, your score will begin to recover after six months of timely payments. With this in mind, I always tell people not to open new lines of credit if they plan on making a major purchase (home or car) in the next six months.

What Makes Up a Credit Score? Part IV: The Type of Credit You Have

About 10 percent of your score takes a look at the type of credit you have. This considers not only the mix of credit, but also the presence / lack of presence of harmful credit.

The Type of Credit You Have Component #1: The mix of credit.

Ideally, you should have:

  • Between three and five major revolving credit cards (which include Visa, MasterCard, American Express, and Discover, but not retail store accounts).
  • A mortgage.
  • An installment loan (usually a car loan, but could also be a loan for a boat, piece of furniture, household appliance, or electronic equipment).

Most people know that having too much credit will hurt their score. After all, the credit-scoring models know that people with a ton of credit can easily become overextended. But what you might not know is that having too little credit will also hurt your score. The credit-scoring models need information about your ability to manage debt. Without this information, they have no ability to give you a credit score. Better safe than sorry, they think, and they assign you a low credit score.

Think of it like this: Let’s say you are scheduled to take an exam at 8 a.m. on Friday. You must pass the exam, or you will not be given a license to perform heart surgery. You oversleep, your child’s babysitter is late, and your car gets a flat. Needless to say, you miss the text. Do you think you will be certified to perform heart surgery? No way! Without the results of the test, the licensing boards will take the safe route.

Likewise, if you have not given the credit-scoring models any evidence as to your ability to manage credit responsibly, you will have a low credit score. You might even have a lower score than someone with a poor credit history. The credit-scoring models want to see that you have the discipline to manage debt and high limits. If you do not have credit, they have no evidence one way or another.

With this in mind, make sure you have:

  • At least three major revolving accounts. If you do not have three, apply for secured credit cards (if your credit is poor) or non-secured credit cards  (traditional credit cards reserved for people with good credit).
  • An installment loan. Some people mistakenly believe this requires them to apply for a car loan. This is not true. Be sure to read our article about how to fix credit by adding an installment loan.
  • When the time is right, your credit score will benefit even more by adding a mortgage. Of course, you should never buy a home just to increase your credit score. This is simply a note to say that paying a mortgage on time is one of the best things to happen to a credit score.

The Type of Credit You Have Component #2: The one type of credit you should always avoid.

One type of credit will always hurt your score. If you apply for a buy now, pay nothing for six months loan, your score will decrease. Accounts that allow you to delay payments for more than a month after purchasing an item are called finance accounts, and they will always hurt your score.

Finance accounts are often hard to detect. Perhaps they allow you to defer interest. Some allow you to pay interest only for a specific period of time. Most often, these loans are advertised by retail outlets that sell major household items:

  • A sofa company announces that you can buy a couch today (October 11) and pay nothing until June.
  • A mattress company has a huge sign that reads: “Sleep in a new bed tonight. Pay for it next year!

These are often tricky to spot because they appear to be retail accounts. Retail accounts are store-specific credit cards that require payment every 30 days. Though I suggest that you never apply for retail credit cards, they do not hurt your credit score, so long as you manage them responsibly. Some retail accounts have billing cycles that are longer than 30 days, but these accounts are not considered finance accounts. Rather, they are revolving credit accounts that lengthen the billing cycle instead of delaying payments.

Like I said, finance accounts can be tricky to spot. A good rule of thumb to make sure you keep pesky finance accounts off your credit report is this: Always speak directly with bank representatives if you are ever in a store applying for a line of credit. The store representative most likely will not know the difference between a finance account and a retail account. Ask the bank representative directly to determine how the item will be reported to the credit bureaus, or refuse the account.

These accounts hurt your score for several reasons:

  • Part of your credit score is determined by your balance-to-limit ratio, so your score could be negatively impacted by finance accounts because your balance will be 100 percent of your limit until you start making payments. Worse yet, as interest grows, it might be more than 100 percent your limit!
  • These loans suggest that you are in a financial bind and cannot afford to make immediate payments. If you cannot make the payments now, the credit-scoring models will assume you will be unable to make them in the future.

Finance accounts are the only type of credit account that will hurt your score every time. For this reason, I suggest that you never apply for them, especially if you are planning on making a large purchase in the next few months.

Occasionally, you might be in a position where your credit can afford to take a hit. Let’s say that your credit score is 800, you have plenty of money in savings, and you have no intention of making a large purchase in the next few years. You set out to buy a new sofa, and you learn that you can purchase a sofa using an installment loan that does not begin to accrue interest for six months. Might it be wise to keep your money in savings, earn some interest, and pay the loan off in five-and-one-half months? Perhaps, but rest assured that your credit score will drop!

What Makes Up a Credit Score? Part V: Credit Inquiries 

About 10 percent of your credit score is determined by the number and presence of credit inquiries. But only certain types of credit inquiries will hurt your score. Let’s take a look at the difference between hard inquiries and soft inquiries.

Hard Credit Inquiries

Hard credit inquiries are the only type of credit inquiry that will hurt your credit score. Your score will be hurt only by inquiries made by lenders for the purpose of determining whether to extend a loan or credit card to you. These are called hard inquiries. The credit bureaus see too many inquiries as potentially risky, figuring you might be preparing to go on a credit card spending spree.

This is particularly harmful if your credit history is limited and/or young. If you are 18, have never had a loan or credit card, and apply for three credit cards, your score will be in the trash. If you have had a solid credit history for 20 years and apply for three credit cards, you score will not drop as much. And if you only apply for one credit card, your score will not drop much at all.

Some things to keep in mind about hard credit inquiries:

  • Only inquiries within the past year will affect your score, though they will stay on your credit report for two years.
  • Credit bureaus make exceptions for people who are shopping around for the best home loan or car loan, counting all loan officer inquiries within a 30-day period as just one inquiry.
  • Having one or two inquiries during the past six months is not going to hurt your credit score by more than a few points, so long as you have a solid credit history.

Soft Credit Inquiries

Your score also will not be hurt if you pull your own credit report, or if someone else pulls your credit report for non-lending reasons. If you request your own score, the inquiry will show up on your credit report as a soft inquiry. Unlike hard inquiries (those pulled by lenders for the purpose of determining creditworthiness), soft inquiries do not affect your credit score.

Other credit inquiries that do not hurt your credit score (soft inquiries) include:

  • Inquiries from landlords determining whether to rent you a home.
  • Inquiries from employers who are pulling your credit report to determine whether they want to offer you a job. (If you are in the job market, be sure to read about credit scores and jobs.)

And even hard inquiries do not affect your score for long. Credit inquiries affect your score for only one year, although they stay on your credit report for two years.