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Week 4: Credit
Today’s Easy Financial Task: Learn how your credit score is calculated
How to rock this task :
- Learn the five components of your credit score and how much weight each component carries
- Identify which components are hurting and helping your credit score
Let’s get this party started…
Today I’m going to show you the magic formula of how your credit score is calculated. There are five key components of a credit score and each component plays a weighted role in your financial future.
The five components are:
- Inquiries: 10%
- Type of debt: 10%
- Length of credit history: 15%
- Utilization: 30%
- Payment history: 35%
1) Inquiries: 10%
An Inquiry happens when your credit report is looked into. Each time you authorize (usually by supplying your social security number), someone other than you access to your credit report, your score potentially goes down by 8-30 points. Sometimes, it is necessary to have your credit report pulled; for example, reports are requested when you apply for certain jobs, rent a car, get car insurance, open up a new credit card, or apply for a loan. Remember to be careful when allowing someone access to your credit. You may be unnecessarily sacrificing credit score points and inquiries that will stay on your report for two years.
Inquiry Example: Applying for a store card at the register in order to save 15% on your purchases.
Inquiry Tip: Did you know that Inquiries from store cards take the most points off of your credit score? Inquiries also stay on your credit report for 2 years.
2) Type of Debt: 10%
The three main credit bureaus, Experian, TransUnion, and Equifax, like to see different types of debt. If all you have are student loans, you look like an inexperienced debtor who may not be able to handle other kinds of debt. I’m not suggesting that you get into debt for debt’s sake. I just want you to be aware of what the credit bureaus look at when assigning you that all important number...your credit score.
Type of Debt Examples: Credit card, student loan, mortgage, car note, personal loan
Type of Debt Tip: If you’re on the market for a mortgage, being great with credit cards won’t help you much. Instead, get a notarized letter from your current landlord stating your on-time payment history and bring a copy of at least two years of bank statements to support the letter.
3) Length of Credit History: 15%
The longer you’ve had credit, the better. Be sure to keep that in mind when deciding whether or not to close a credit card. You may want to consider closing one of your newer cards instead. Your older cards are proof of a longer credit history. The length of your credit history is an average of all of your open credit accounts. Be careful of opening up too many new accounts because they will bring the length of your credit history down.
Length of Credit History Example: I’ve had my mortgage for 10 years, a credit card for 15 years, and another credit card for 5 years. My length of credit history is: 10+15+5 / 3 = 10 years.
Length of Credit History Tip: As awesome as it is to pay off a car loan, student loan, or mortgage, you may temporarily lose some credit score points when you do. The reason? Now that those accounts are paid off and closed, they are no longer included in your Length of Credit History calculation. The trick is to always keep your oldest credit card open. It’s revolving credit, and unlike a loan, a revolving account doesn’t automatically close when the account reaches a $0 balance. It usually remains open and available for use until the lender or the consumer (you), chooses to close it.
4) Utilization: 30%
Your utilization is how much of your credit limit you’re using. For example, if you have a credit card with a $500 limit and your balance is $250, that means your utilization is 50%. That’s way too high. Ideally, you DO NOT want to use more than 30% of your limits, under 20% is even better if you're trying to raise your credit score. A ratio that is too high may mean you’re unable to make consistent, on-time debt payments. The higher the ratio, the higher the interest rate you might be charged on your debt and no one likes that.
FYI: Your limit is calculated as an average just like your length of credit history.
Utilization Example: If you have two credit cards with the same limit ($500 each) and one of them is maxed out and has a balance of $500 and the other one isn’t being used and has a $0 balance, you’re utilizing 50% of your available credit.
Utilization Tip: Here’s a step-by-step guide to help you figure out if you should close or keep your credit cards:
- List ALL of your revolving credit accounts.
- Add up your credit limits.
- Add up your current balances.
- Divide your balance by your credit limit.
- Multiply your answer by 100.
- If your current credit utilization ratio is 20% – 30% or higher, then you should not close any of your credit card accounts.
- If your ratio is below 20%, recalculate your ratio, but do so without your newest card.
- Keep dropping the newest card on your list until you find how many cards you can keep and still have a credit utilization rate under 30%.
5) Payment History: 35%
This component of your credit score carries the most weight. Basically, it measures whether or not you pay by the due date, and whether you pay at least the minimum amount required.
Payment History Example: If your credit card bill is due every month on the 15th, by paying at least the minimum amount requested on or before the 15th, you keep this component of your credit report in good standing.
Payment History Tip: Automation is the new discipline. During Day 11 of the Challenge I encouraged you to open multiple bank accounts. One of these accounts is a Bills Account. Use your Bills Account to automate payments to your creditors. Doing so will help improve your credit history and overall credit score.
We've talked about www.creditkarma.com throughout this Challenge. It's not only a place where you can pull your credit report, but it's also a great resource to educate yourself on what factors are impacting your score. It's completely free! Sign up for Credit Karma here: http://thebudgetnistablog.com/creditkarma
Learn Something New? Yes?
Share what you learned with me in the comments below & in our LRC Forum.
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