Credit Scores

Developing an intentional relationship with our finances is critical for crafting the life we want. It gives us the ability to take a resource (money) and transform it into a lifestyle reflective of our values. Whether you make $20,000 a year or $150,000 a year, understanding basic financial concepts is crucial for increasing freedom and lessening fiscal anxiety. In learning more about these topics and living below my means, I was able to save up months of expenses and leave my job that didn’t bring me long-term satisfaction.

Credit scores are one of these fundamental topics. Unfortunately, there is a disproportionately small amount of education dedicated to a metric that impacts so many of us. It’s understandable why many of us lack basic knowledge of how credit scores are calculated or affect us. If you have a mortgage, student loan, auto loan, or credit card, you’ve impacted your credit. If you have applied for car insurance or keep a utilities bill in your name, you’ve had your credit checked.

I’ve only been building my credit for 5 years, but I have learned a fair amount since those early days. I first discovered many of these insights when I began travel hacking my way to free flights and increased world travel. To do so, I needed to develop a greater understanding of credit cards and how they impact my score. Now I want to pass this learning onto you. Regardless of your current finacial habits or knowledge, this information will provide you with a useful foundation.

Why Credit Scores Matter

Like so many other long-term investments, building credit is something you want to begin as soon as possible–and it’s never too late to start. While most people rarely discuss their score, there are a times in our lives where this number plays a critical role.

For example, financial institutions use credit scores to weigh the terms and interest rates of mortgages and credit card applications. Over the life of a typical 30-year mortgage, higher rates mean higher costs to you, the consumer. If you carry a balance on your credit card each month, that interest rate impacts how much you pay. It can also affect your ability to rent an apartment or receive low auto insurance rates. Therefore, it is worth developing some healthy financial habits in the event of future loan or mortgage applications. This will put you leagues ahead of your peers.

The score itself is a number between 300 and 850 which represents your credit worthiness to potential lenders. It provides the inquirer with a better idea of your ability to repay loans. As you might guess, higher scores are better with good scores north of 700. Your credit score is compiled by three credit agencies or bureaus: Equifax, Experian, and TransUnion. In addition to credit scores, these three entities also maintain a financial document known as a credit report on each person. The report contains previous addresses and telephone numbers, a list of open or closed credit lines, and a monthly payment record as reported by financial institutions. Think of this as your financial permanent record.

If this is starting to sound a little “behind the scenes”, that’s because it is. Whether you were aware or not, a record exists of your financial decisions and I want to help you keep it clean. Regardless of your choices so far, there are five factors we can improve upon to strengthen your score.

The Five Factors

Most folks impact their credit score via auto and student loans, mortgages, and credit card debt. More serious events such as foreclosure and bankruptcy undoubtedly affect your credit score as well. Although I didn’t have a credit card until 19, the federal government dispersed me a student loan the previous year thus kick-starting my credit journey. Perhaps some of your parents were thoughtful enough to make you an authorized user on their credit cards at a young age. Hooray, this means you already have a credit history!

Regardless of your current score, let’s figure out how it’s calculated and construct a framework for increasing it. While not completely transparent, it is generally understood agencies weigh factors in the following ratio:

  • Payment History (35%)
  • Credit Usage (30%)
  • Age of Credit History (15%)
  • Account Mix (10%)
  • Credit Inquiries (10%)
credit_sesame-1170x563
A snapshot of my Credit Sesame dashboard providing me with a grade in each of the five categories. While this breakdown isn’t available from a bureau, the graphic will help explain the factors.

Payment History (35%) tracks negative marks against your borrowing such as late payments on a loan, foreclosures, or bankruptcies. Paying your bills consistently and on-time is the name of the game. My Credit Sesame dashboard reveals I’m doing a great job with this. Protect yourself from late payments by setting up automatic bill pay as soon as you begin repaying any loan.

Credit Usage (30%) is a ratio of how much credit you use divided by the total available credit to you. Putting $2k per month on a credit card with a $10k credit limit will give you a 20% utilization. I also get an ‘A’ in this category because I spend no more than $1500 of my available credit which works out to less than 10%.

These two initial factors are far and away (65%) the most important contribution to your score. Using between 10-20% of your available credit and paying your statement in full and on-time every month are fundamental principles for general credit card use, let alone travel hacking. Notice that despite having lower marks on the remaining factors, I still have excellent credit! Let’s wrap up the last three and find out why.

Age of Credit History (15%) looks at the length you have each line of credit. Keeping a credit card open or continuing to make mortgage payments extends the length of your lines of credit. This long-term and consistent payment record communicates your responsibility and trustworthiness to bank. Credit Sesame’s algorithms give me a ‘D’. Given my credit hacking lifestyle (admittedly atypical), most of my accounts only last 10-12 months. The exception to this rule are my original no-fee credit cards which I’ve maintained for over 5 years. These long-term cards balance out my overall average length of credit. My student loans lasted the course of my undergraduate career and definitely helped develop my long-term repayment history as well. For the average Joe Consumer, you should begin building credit with a no annual fee, cash back card with a bank/credit union you enjoy doing business with. Plan on keeping this open for a long time.

Account Mix (10%) looks at the diversity of your credit lines. For example, having a mortgage, two credit cards, and an auto loan shows more creditworthiness than someone with only one student loan. In my case, I only have a handful of credit cards. While I do receive a ‘D’ in this category as well, it’s only 10% of my overall score. I have no desire to simply open a loan for the sake of improving this factor and don’t recommend anyone else doing it either. I would always prioritize eliminating a loan over improving this factor.

Credit Inquiries (10%) tracks the number of times a financial institution has reviewed your credit score over the past 12 months. Although I apply for a new credit card every 3-6 months to support my travel hacking, Credit Sesame views this as ‘B’-worthy. Limiting the amount of times financial institutions check your credit score is the best recipe. Of course, sometimes it’s just a necessary evil of applying for a mortgage, opening a credit card, or submitting an apartment application.

More On Credit Reports

Now that we have a better grasp on our scores, lets return to that idea of a credit report–recall it acts like a financial permanent record. Below is an excerpt from a TransUnion credit report I requested last week. It details the payment history of my Barclay’s Hawaiian Airlines card. Opened in late November 2015, I subsequently used this credit card during my January trip to New Zealand. After surpassing total purchases of $3k in the first three months of card membership (January through March), I received 50k bonus miles. Although I don’t run any more bills through this card, I keep it open to support my credit score. Even though I don’t charge a single dollar to the card, I receive an “OK” rating on my report. The beautiful green bar across the bottom designates my good standing and on-time payments. This makes my credit score happy!

credit_report.png
A sample of my TransUnion-generated credit report. Keep those cells green, folks!

Note the Scheduled Payment of $25 listed in the table above. Do not be fooled into making minimum payments as you will be charged interest on the remaining balance (whatever is over $25). I never recommend spending beyond your means–always pay off your credit card in full at the end of the month. This is a great habit to get into regardless of your income or expenses. This is not a magic want, it should be viewed as one tool to help develop your essential life.

Under US law, you can request one free credit report from each major agency (Equifax, Experian, and TransUnion) in a 12-month period. You can rotate between them receiving a report every four months or just opt for an annual report like I do. This helps me monitor fraudulent loans or any missed payments I should dispute. Like I mentioned before, you don’t actually see your credit score on the report, but there are other ways to keep tab on this metric. If you want to maintain monthly tabs on your score as I do, Credit Karma and Credit Sesame are two great websites and mobile apps. It doesn’t always reflect your score from the three major agencies exactly, but it’s quite close. In doing so, you can see how your individual credit profile reacts to credit card or loan applications.

Money isn’t everything of course, but it is one resource in which we can use to our advantage. If we choose to design essential lives, curating a responsible attitude towards our personal finance is extremely beneficial. Understanding the five factors listed above will help increase and maintain a great credit score. Those who do so are rewarded with lower interest rates, viewed as more trustworthy, develop more financial flexibility, and can even dabble in free airline miles if they desire. And in an America where financial literacy is relatively low, you will be steps ahead.

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