Around 10 pm on a rainy Friday night toward the end of a particularly rainy May in Madrid, I left my office at IE Business School, collected my car from the garage and began my drive home from the…
Know Your Credit Part 1: One of the most frustrating things that I encountered while trying to understand my credit score was attempting to piece together all the scattered information on the subject. It is impossible to go to one place and get all the information you need, caveats and side notes included. The confusion led me to some poor financial decisions. Being that I do not want you to face the same difficulties I will create a string of blog post, that if followed in order will give you a complete understanding of credit scores in snack sized bits. All so you can digest it without being overwhelmed. At the end you will be the expert and run me out of town.
Put simply your credit score is a grown up report card. Financial institutions, individuals, and any other entity looking to do business with you will use your credit report as a way to judge you: are you financially healthy, responsible, experienced and diverse?
Who are the teachers grading you? The answer is more complicated than most professionals will admit. Still you shouldn’t worry; I am not very smart and I managed to get it, so I am sure you will understand this all in no time. Let’s start with the main three: Equifax, Experian, and TransUnion. (FICO is not a credit bureau). These companies receive information from your credit cards, loans, and other financial obligations and use it to determine your score.
How do they judge you? I am glad you asked. The breakdown is as follows:
Payment History: Do you pay on time every time? Have you missed any payments? Do you have any delinquent accounts? This composes 35% of your credit score.
Credit Limit: How much of your credit limit do you use? This mostly applies to your credit cards. The credit bureaus like to see that you are using 30% or less of your credit. The less the better. Usage over 30% is viewed as risky. This composes 30% of your credit score.
Credit Age: This is calculated by taking the average of your accounts. For example, you have 3 accounts: one for 10 years, one for 5 years, and another for 2 years, in theory what is the age of your credit history? 5.67 years or approximately 6 years. This composes 15% of your credit score.
Credit Type (Mix): This includes credit cards, auto loans, student loans, mortgages, personal loans and any other accounts that report to the agencies. It is really important to have a mix of both credit card history as well as loans. Financial institutions like to see that you can responsibly handle credit card payments as well as installment loans. This composes 10% of your credit score.
Hard Inquiries (sometimes referred to as New Credit Lines):
These are request to open a line of credit; for example, credit cards, auto loans, mortgages etc. It is best to think of them as Hard Inquiries because they stay on your report whether or not you are approved for the credit line you applied for. This composes 10% of your credit score.
While it is important to have a full understanding of the metrics by which the credit bureaus score you, they are not set in stone. There are plenty of caveats and ignoring them can lead to poor financial decisions and unpleasant surprises when seeking to borrow money.
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