Beginner Series Part 3:
How Credit Scores Work

Your credit report will play a critical role in helping you to get approved for new credit cards. It is the key piece of information that banks use to determine whether you are likely to pay them back if they approve you for a card. In this article, we will discuss all of the factors that make up your score, tips on how to improve your score, and some items on your report to watch out for before you apply for new cards.

Factors that affect your credit report and score

Your credit report is comprised of several factors that users lend to determine your creditworthiness. It is a snapshot of your balances, payment history, credit utilization, open and closed accounts, and negative items (collections, missed payments, bankruptcies). Each of these factors is reported by lenders and is updated each time a billing cycle has closed. As these factors are updated, different credit scoring models update your scores depending on what factor in your report changed and how much weight that factor has in the scoring model. See below for the breakdown of the factors that make up your score.

Payment History - 35%

This factor measures your history of on-time and late payments.
It is the most heavily weighted factor among all five, so don't miss ANY payments!
If you do have missed payments, it won't completely ruin your chances of being approved for cards.
The older the missed payment becomes, the less it negatively impacts your credit score.
If you have any recently missed payments in the last 12 months, it COULD be a factor for denial.
I recommend waiting until your most recent late payment to age to at least 12 months before applying for any new credit, because you want to make sure that you are adding inquiries to your report that result in approvals.

Amounts Owed (aka Card utilization) - 30%

This is your total personal credit card balances as a percent of your total credit card limits.
An example: if your total credit line is $50,000 across all of your accounts, and you're using $15,000 of that total line, then your total utilization is 30%. ($15,000 / $50,000)
The recommended utilization level is to stay below 30%, but not always 0%.
Your TOTAL credit card balances are sometimes considered, and you should keep this at roughly 15% of your annual income or less.

Length of Credit History - 15%

Your length of credit history is the average age of ALL credit accounts.
This factor also includes your oldest age of account, which gives creditors an idea of how long you have been using credit
Creditors use this factor to determine two things:
- your length of experience borrowing and paying back creditors
- the likelihood you will keep an account open for long
As you open new accounts, your average age of accounts goes down because those new accounts skew the average age lower. The same goes for closing accounts because could stay on your report for as long as 10 years even after closing it.
To optimize this part of your report, don't open any new accounts any sooner than 6 months after the previously opened account.

New accounts opened and inquiries in the last 24 months - 10%

Your length of credit history is the average age of ALL credit accounts.
This factor also includes your oldest age of account, which gives creditors an idea of how long you have been using credit
Creditors use this factor to determine two things:
- your length of experience borrowing and paying back creditors
- the likelihood you will keep an account open for long
As you open new accounts, your average age of accounts goes down because those new accounts skew the average age lower. The same goes for closing accounts because could stay on your report for as long as 10 years even after closing it.
To optimize this part of your report, don't open any new accounts any sooner than 6 months after the previously opened account.

Credit Mix - 10%

This part of your report is based on the different TYPES of credit accounts that appear on your report.
Having a variety of revolving credit, a car loan, a mortgage, student loans, personal loans, etc. will optimize this part of your report.
This part is probably the least acknowledged among the other four factors, but it should not be ignored.
DO NOT open a new loan type for the sake of showing a better credit mix, it's not as important as other factors like paying your balances on time!

Factors that affect your score

5 Common myths and misconceptions about your credit

Credit reports can seem like a black box to some due to all of the factors that go into it. It's not like there's a set of instructions that come with your credit report to help explain every line of your report, but that's why we're here - to help you better understand the things that you may not be familiar with. Below are a few common general misconceptions about credit scores followed by the truth about those misconceptions. Let's dive in.

Common myths about credit

Myth: Your income affects your score

Truth: How much you make has no impact on your credit score. However, it COULD be a factor when lenders review your application. This is especially true when applying for higher-end cards, like the Chase Sapphire Reserve. Your income could sometimes make up for a less favorable credit score, but it does NOT affect your score itself.

Myth: Checking your credit lowers your score

Truth: Simply put, checking your score does not lower your score. I check mine multiple times a day, and it's become excessive at this point, but I can assure you that my score was not impacted by it.

Myth: Your personal information affects your score

Truth: Things like age, your zip code, your race, gender, and other personal information does not affect your score. However, you should make sure to keep this information up to date to avoid discrepancies, which could be viewed as ref flags by lenders.

Myth: Negative items on your report cannot be removed

Truth: This is KIND OF true, but you can dispute discrepancies on your credit report and get them removed if you can prove that they are not accurate.

Bonus tip: Hiring a third-party credit repair service like Lexington Law can help to dispute any discrepancies on your behalf. I used them early on when my credit score was a whopping 530, and they were able to remove about 10 negative items, which helped to boost my score quite a bit. However, these third-party services can be pricey, so make sure you choose a reputable firm with proven results before doing so.

Myth: You have to pay to get the most reliable credit score

Truth: You don't have to pay any service at all to check your credit score. Experian will give you access to your score, score alerts, and full report for free once you register. Along with Experian, you can register with myFICO for free to have access to your Equifax report to give you more data, and you can round it out with Credit Karma, which will give you the VantageScore version of your TransUnion and Equifax reports with real-time updates and complete data points. These three tools are more than enough to give you a full picture of your credit report without having to dish out any money.

How to improve your credit

Now that you know the ins and outs of credit reports, it's time to get working on getting it into top shape. To wrap up this post, I'll share proven some ways that have helped me to improve my credit.

Make a budget and stick to it

When I was in college, I struggled with time management. When I met with my advisor, she gave me some great advice that will stick with me forever. Her advice was "If you ink it, you'll think it. If you don't, you won't." In other words, there is a lot of power in writing things down and tracking them. the act of writing something down tends to burn that thing into our memory and not forget it. It also helps to keep you super disciplined in paying things on time and not missing any payments.

Pay more than the minimum payment each month

When you're trying to pay down debt faster, every little bit that you can pay on top of your minimum payment will help. There are two techniques I tend to recommend. For the sake of simplicity, let's assume you can afford to pay up to an additional $100 per month towards your debt.

Technique 1: Debt Snowball Technique (my recommendation)

Choose the lowest balance owed. Pay the minimum payment + the extra $100 per month. Pay the minimum payment on everything else.
This helps to more quickly free up cash that you would have been using to pay down this debt.
For example, let's assume your lowest balance is $500 and the minimum payment on that debt is $60. Once that balance is paid off, now you have an additional $60 you can use each month PLUS the extra $100 per month.
Apply this same technique to the next lowest debt by paying it down with the extra $160 per month.
Continue until all debts are paid off.

Technique 2: Debt Avalanche Technique

Choose the balance with the highest interest rate. Pay the minimum payment + the extra $100 per month. Pay the minimum payment on everything else.
This helps to reduce the total amount of interest you are paying over time.
For example, let's assume your highest balance is $10,000 and the minimum payment on that debt is $200. Once that balance is paid off, now you have an additional $200 you can use each month PLUS the extra $100 per month.
Apply this same technique to the next highest interest rate debt balance by paying it down with the extra $300 per month.
Continue until all debts are paid off.

Why I don't recommend #2: It could take a relatively long time to pay off this debt and you won't free up any new cash flow as quickly as you would in #1. However, if your debts are all relatively the same balance, then this would make sense.

Dispute negative items on your report

If you find any discrepancies on your credit report, dispute it with your creditor. You will have to do some digging into your report to find any discrepancies, but this could be an easy way to get negative items like missed payments removed from your report. These can be simple mistakes such as misspellings or incorrect account numbers on your report. If any details you find are not EXACTLY what you expect them to be, it's worth filing a dispute with the creditor.

I should mention that it can be a hassle to file a dispute, which requires submitting a form and waiting for a response, which takes an indefinite amount of time. If you want to go this route but skip the hassle, look into a third-party credit repair company to do this grunt work on your behalf. Trust me, it's worth it.

The point is...

A strong credit report can save you a ton of money in the long run. Those with higher scores and cleaner credit reports tend to get access to lower interest rates on car loans, mortgages, and other forms of credit that are typically used for larger purchases. In the case of travel rewards, it opens up many more opportunities in that it gives you a better chance of gaining access to the most valuable cards in the industry. If your credit needs work, be patient. It took me 7 years to go from a score of 530 to my current score of 790. If you can get your score up to at least 670, then you should be able to access some entry-level rewards cards. To access the upper-echelon tier of cards, aim for a 750 or above.

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Beginner Series Part 3: How Credit Scores Work