The Anatomy of a Credit Score

Many of you are trying to improve your credit scores before you can, say, buy your home. But there is a lot of confusion and misinformation out there on just how to do that. By not understanding what credit scores are based on, you can hurt your scores by doing the wrong things.

For example, how many of you have been told that you should close your old inactive credit accounts to improve your score? The logic of this advice is that future lenders will get scared off if they see you have access to too much credit. This is completely untrue.

The “Safety Net” Factor

In fact, having extra credit available creates a “safety net” for your finances. If you had an emergency, like your three-legged, half-nosed dog “Lucky” got himself caught in the garbage disposal again and required some emergency surgery, you’d have the safety net of credit available to take care of the unexpected expense rather than being forced to skip payments on your regular bills.

Creditors LIKE seeing extra credit and one of the most common credit score mistakes is closing accounts. Do not close any accounts – even “bad” accounts – before you buy your home or otherwise reach your credit score goals.

What Determines Your Credit Score?

Your credit score is determined by five categories:

• 35% is based on your payment history.
• 30% on your “balances-to-limits” ratio.
• 15% on how long you have been using credit.
• 10% on your applications for new credit.
• 10% on your “mix” of credit.

Most everyone understands that you help your credit score by making your payments on time, but
from the above list you can see that this is only 35% of the story. If you don’t pay attention to the other scoring factors, you’re ignoring about 2/3’s of your credit score.

Your “balances-to-limits” ratio works like this. If you have a credit card with a $1,000 spending limit and you owe $1,000 (maxed-out balance) on it, you will actually lower your score even if you make the monthly payments on time. You should never allow your balances to get higher than 30% of the limit (even mid-month because you don’t know what day the credit card reports your status to the credit bureaus).

Don’t Close Even “Bad” Accounts

15% of your score is based on your length of credit, so if you close old accounts, you’re losing out on the length of those accounts (even if they were bad). This one is very hard for people to understand – and many people make the mistake of paying off an old account and then closing it. Many times (especially in the case of a collection account) you don’t have a choice as the account will get closed automatically once you pay it (and this is why paying off old collection accounts can sometimes lower your score for awhile). But if you have a choice, don’t close the account.

Does It Pay to Save 10% Instantly?

Applying for lots of new credit in a short period of time can lower your score, so try to be smart about how often you do this. Just because you can save 10% on your $30 purchase at the department store if you open a new account, that may not be worth having your credit score lowered. These inquiries will affect your score for 12 months before falling off, so be careful and only open accounts your really want to have.

Mix It Up, Baby!

10% is based on your “mix”. What that means is that you’ll lose points if you have too many finance company accounts (those “No Payments for 12 Months” offers on furniture and appliances). These types of accounts can be great if used properly – just don’t load up on them. And remember, 30% of your score is based on your “balances-to-limits”, and those installment-type loans from finance companies and car lenders don’t have “balances-to-limits”, so in order to get these points (30% of your score), you need a few credit cards in your “mix”. What is the ideal mix? That’s another article…

Related Articles:

• “SAFETY NET” Credit Scoring Factor
• Should You “Opt Out” of New Credit Offers?
• Credit Scoring with Your Credit Card: Magic Number is Still “30”
• Credit Cards – Secrets to Increase Your Credit Score
• Credit Card Debt