Throughout my career as a wealth manager and financial planner, I’ve found that one of the most misunderstood components of our financial lives is credit. Most people understand the basics – you borrow money from a bank/credit card company/mortgage lender and pay interest on the balance. But what many people don’t understand is how their credit scores are determined, and how those scores can impact their overall financial lives.
If you spend any time watching TV or listening to the radio you’ve almost certainly heard advertisements for companies that monitor your credit report and help you raise your FICO scores. But what exactly does that mean? There are three major credit reporting bureaus in the U.S. – Equifax, TransUnion and Experian – who all maintain records of our financial histories and generate a FICO score. Your FICO scores are a big key to how lenders gauge your credit-worthiness. Those scores are comprised of five different types of data: Amounts Owed, Payment History, Length of Credit History, Credit Mix & New Credit.
One of the most common myths I hear about credit is that it hurts your credit score to have too many credit cards open at one time. While that can be the case, the important thing credit agencies look at is what percentage of your available credit you’re using. For example, you could have five credit cards with $10,000 limits, but if you only spend an average of $5,000 per month on them then you’re utilizing just 10% of your available credit. Consistently using a high percentage of your credit limit, or worse, carrying a high balance from month to month, can ding your credit reports and FICO scores. The higher utilization may indicate to lenders that you are at a higher risk of defaulting on a loan and can result in higher interest rates.
Often cited as the most important factor in determining your FICO scores, your payment history lets lenders know whether you typically make debt payments on time. Making timely and complete payments is also one of the best ways to build a good credit history. I occasionally see parents open a low-limit credit card for their children’s spending and pay it off every month. That is a great way to begin building your child’s credit history early on!
Length of Credit History
When looking at the length of your credit history, the bureaus take into account the age of your oldest credit account, the age of your newest credit account and an average of all accounts. Going back to the credit card myth I mentioned above, if all of your credit cards were opened in the past year then this section of your credit report will need some work. On the other hand, having several cards or lines of credit with lengthy histories can actually boost your scores! Many times, when people decide to cut back on the number of cards they have, they start with that first “introductory” card they opened up at a young age. What they might not understand is that closing your oldest line of credit – in hope of having fewer open cards – will actually hurt your credit score rather than help.
This category of data is briefly summarized in the example above: If all or most of your credit cards are relatively new then your average length of credit history will be short. Lenders typically don’t like to see you opening multiple new lines of credit at once as it may represent a greater risk of being able to repay. Because of that, I always recommend avoiding opening new credit cards or other credit lines within 6 months of buying a home, car, etc. in the near future.
The last category credit agencies look at to come up with your FICO scores is your credit mix. This tends to be a minor piece of the overall credit report, but it can provide lenders with a lot of background information on you. This is where the bureaus report on what type of credit you have – credit cards, mortgages, car notes, etc. – and what your limits are in each category.
The importance of the five categories above can vary from person to person based on your unique credit history. Resources such as Credit Karma and Credit Sesame, as well as the three credit bureaus – TransUnion, Equifax and Experian – can all help you learn about your individual scores and reports. Understanding how your credit reports and FICO scores are determined – and the steps you can take to improve the underlying data – can go a long way toward improving your long-term financial health and becoming financially FIT™.
Learn more about this topic and many other ways our FIT™ process could help you build your financial future by contacting us today!