Like their closely related counterpart the credit card, credit scores are often misunderstood. They are crucial to modern life, yet most people don’t get them. I know people who never check their score and others who compulsively follow it (I’ll admit I’m in the latter camp).

Because of how important they are -- and how little they are understood -- there is a lot of misinformation about them. A lot. Today’s article will be a deep dive into what your credit score is, why it matters, and how it can help you.

Why Your Credit Score Matters

It’s easy not to care about your credit score. It can seem obscure. It’s hard to follow. It doesn’t impact your life day-to-day. Credit scores are often overlooked by all except the most obsessive personal finance nerds.

There are several key areas where a higher credit score will have a significant impact on your life. Educating yourself on your credit score is the first step. Working to improve it will help you live a life that excites you that much quicker.

Interest rates

The most obvious use of your credit score is in determining your eligibility for a loan. Next is the interest rate you will receive. Whether it’s a credit card, a car loan, or a mortgage, your credit score determines your interest rate. A higher credit score means a lower interest rate. This can save you thousands of dollars over the course of the loan.

For example, you generally need at least a 580 credit score to qualify for a mortgage. But to qualify for the best interest rates, you will need a score of about 760 or above. Those numbers may not mean much yet. We'll get there. The difference between 580 and 760 will mean tens of thousands of dollars saved in interest.

Better rewards

I’ve talked about this before, but credit cards are a huge part of my strategy for living a life that excites me. I put every single expense that I can on my credit cards. The rewards allow me to travel to a lot more places than I would otherwise be able to. 

Travel may not be as important to you as it is to me (and that’s okay!), but you probably still like free money. Who doesn’t? 

Many of the best credit cards on the market need an “excellent” credit score (generally 720 and above) to qualify. Better cards come with better rewards rates, which means your free money piles up faster.

Banks also often use credit scores to send out targeted offers. Everyone wants a trustworthy customer. A higher credit score signals to lenders and banks that you are trustworthy. I have made several hundred dollars by opening new checking and/or savings accounts through targeted offers. Talk about free money.

Less Money Up Front

Credit has become pervasive in society. More and more institutions are starting to base their decisions in part on your credit score. Like it or not, your credit score has become a proxy for how trustworthy you are with everything, not just with credit.

A better score can be the difference between getting or missing out on that apartment you want. It can also mean a lower security deposit, lower down payments, and fewer fees you have to pay out the door. Combined with the lower interest rates that a better credit score gives you, the savings add up in a hurry.

What It Is

Your credit score is based on your credit report. It is a way to distill your complex history of debts and payments into a single number. That seems simple enough, but it gets pretty complicated. To start with, there are 3 main Credit Reporting Bureaus: Equifax, Experian, and TransUnion. Every lender has their pick of which report or reports they look at to calculate your score. They also get to choose which bureaus they report to themselves. Some items will show up on one report but not another.

It gets one step more complicated because how your score is calculated can vary as well. In general, services that offer you a free credit score are providing you with a VantageScore. The VantageScore is a proprietary system developed by the 3 main credit bureaus. While it is starting to gain traction, it is nowhere near as popular with lenders as the FICO Score. 

Both FICO Scores and VantageScores are on a scale from 300 to 850. The closer you are to that 850 number, the better your credit is. While it’s important to know your score, it’s also important to know what you're checking. VantageScores and FICO scores will vary from each other. Most banks still use the FICO model I will outline below. 

Also, there are “specialty” scores that go up to 900 for certain types of loans, such as auto loans.

All that is to say, knowing your score is important, but bear in mind the bank is seeing a different number than you are.

How It’s Calculated

Before we get into the numbers, 2 quick notes. 

First, I will only be breaking down the FICO Score. That is more widely used by lenders and more straightforward. VantageScore does not report percentages as FICO does, only how “influential” various factors are.

Second, FICO does not release exactly how they calculate and scale your score. They only release the factors involved and how each is weighted.

Okay, on to the math.

Payment History

This is the largest single factor in your credit score, at 35 percent. Lenders like to see that you always make your payments on time. The quickest way to hurt your credit score is to start missing payments, as even a 99% on-time payment percentage is only “average.” Do your best to keep your on-time payments at 100%, even if you can pay only the minimum in a given month. 

If your payment history isn’t perfect, that’s okay too. Nothing stays on your credit reports forever. Get started right now on your payments and trust that you’re making progress.

Amount Owed

Up next is the amount owed. This makes up the next largest percentage of your score, 30%, and also represents one of the easiest places to improve your score. Amount owed is not based on an absolute number ( $1000 = good, $10000 = bad), but a relative number. 

Lenders like to see that you are keeping your utilization below 30%, and ideally below 10%. So if you have a credit card with a $1000 limit, you want to make sure you never put more than $300 on that card.

If your utilization is above that, it’s pretty easy to fix. The best solution is to pay off the debt to bring your utilization down. If that isn’t possible right away, you can call your credit issuer (or go online!) and request a credit line increase. If you’re approved, that lowers your utilization without changing the amount you owe. 

There is one important caveat here: DO NOT request a credit line increase if you haven’t tackled your underlying spending habits. Something caused you to go above 30% utilization. You’re only going to go deeper into debt if you haven’t addressed that yet.

If you don’t know what’s wrong with your spending habits, or where to begin to change them, start by signing up for our FREE email course: The Budgeting Roadmap.

Length of History

Next up, at 15% of your FICO score, is the length of your credit history. The longer you have had credit, the more responsible you are with it to lenders. Keep your accounts open and always pay on time. You will see your FICO score trend upwards as the years go by. 

There is no shortcut on this one. You just have to wait. Banks are looking at both the age of your oldest account, and the average age of all your accounts combined.

New Credit

“Doesn’t applying for new credit cards hurt my credit score?” Yes. Yes, it does. But the effects are minimal and short-lived. New credit makes up only 10% of your FICO score. Credit is only new credit for 12 months.

When you apply for any new type of credit, the lender issues what is known as a “hard pull” on your credit report. This pull will stay on your credit report for 24 months. The biggest impact on your credit score will be immediate. After that, your credit score will gradually increase each month. After 12 months, that hard pull no longer affects your score, and after 24 it goes away completely.

Don’t go out and apply for 12 credit cards tomorrow, but remember that new credit only hurts you for about a year. Even then it only makes up 10% of your overall score. It’s a small piece of the pie.

Types of Credit

The final 10% (somebody check my math. Did we get to 100?) comes from your credit mix. Lenders like to see that you have more than one type of credit account. These can be credit cards, car loans, student loans, mortgages, or anything else that gets reported to the credit bureaus.

Don’t stress too much about this one. You will build up different types of credit as you live your life, and it’s only 10% of your score anyway. Going out and getting a car loan you don’t need to improve your credit mix is a terrible idea.

Things That Don’t Help

Now that we’ve covered what is on your credit score, let’s go over what isn’t. These are a few things that people often believe affect their credit score, either positively or negatively. Most of these actually have the opposite effect from common wisdom.

Carry A Balance

So many people think you need to carry a balance each month to improve your credit score. This is not only wrong, it’s dangerous. The lower your utilization is, the better your score. That holds true all the way down to zero. All carrying a balance does is cause you to pay interest. If you aren’t careful, you’ll end up over your head in debt.

Lower Your Credit Limit

I’m of two minds about this one. If you have a spending problem that you can’t seem to reign in, absolutely lower your credit limit. Stop the bleeding, and make sure you limit the damage.

However, don’t think that lowering your credit limit will improve your score. It will more than likely have the opposite effect. When you lower your limit, your utilization will go up. Until you get this debt paid off, your score is going to take a hit.

Cancel Your Cards

With very few exceptions, this is one of the worst things you can do for your credit score. Unlike lowering your credit limit, this will have long-term negative implications on your credit score. Once an account is closed, it will eventually be removed from your credit reports. You can’t get that account history back, your average account age drops, and your score takes a major hit.

Some people are compulsive spenders with way too many cards, and they need to cancel some of them. That’s okay. I always urge people to keep at least their oldest account open to help their average age of credit.

The other time it makes sense to cancel is if you have a card with an annual fee you no longer use. Before you cancel though, call the card issuer and see if you can downgrade to a less rewarding card that doesn’t have a fee. This will let you keep your account history.

How to Improve It

I was going to address a few ways to improve your credit score here, but this article has gotten pretty long as it is. Look for that to come soon in its own article. In the meantime, send me an email if you have any questions or see anything I overlooked.

Conclusion

People do a lot of weird stuff in the name of improving their credit score, and most of it stems from a lack of knowledge. By knowing what affects your credit score and how, you can make smart decisions about credit. That will help save you tens of thousands of dollars throughout your life.

(P.S. Struggling with debt? In over your head with credit cards? Can’t seem to stick to your budget? Our completely FREE course: The Budgeting Roadmap is out now! Sign up HERE!)