Your Credit Score #1

Oct 28, 2014 by

range of credit scoresAre you mystified by your credit score and have little idea of what you should be doing to boost it? If “yes” (or “huh?”) that’s excellent because with this post I’m launching a series explaining—briefly and clearly—each of the five components of the popular FICO® credit score.

Why You Should Care About Your Credit Score

I think Americans are overly obsessed with their credit scores, thanks largely to heavy marketing by the companies who make money selling scores by exploiting Americans’ competitive nature! I’ve never paid money to learn my credit score. Moreover, I don’t even know what my score is! BUT, I do know clearly what I should be doing and not doing to maximize my credit score. I figure if I’m educated about how credit scores are calculated and act accordingly, my score will be as high as it can be—whatever it is!

Understand please I’m not saying your credit score—or more accurately, your credit rating—is unimportant. On the contrary, maintaining good credit is essential to frugal living. Don’t assume your credit rating only matters if you plan to borrow money. Credit scores impact even folks with no debt and no plans to borrow. Read “Who Checks Your Credit Score?” to learn the details.

Credit Score Elements

Very simply, the five elements of the FICO score, and how much each element is weighted in the score, are:

  • Payment history — 35%

  • Credit utilization — 30%

  • Age of credit — 15%

  • Mix of credit — 10%

  • Credit inquiries — 10%

The remainder of this article will focus on credit utilization, which comprises a whopping 30% of your credit score.

What Is Credit Utilization?

FICO defines credit utilization as

→ the total outstanding unpaid balance on all of your credit cards

divided by

→ the total credit limit of all these credit card accounts combined

Say you’ve got three credit cards with these balances and limits

Card A: $300 balance, $2,500 limit

Card B: $1,200 balance, $5,000 limit

Card C: $3,100 balance, $6,000 limit

Your credit utilization is

($300 + $1,200 + $3,100) ÷ ($2,500 + $5,000 + $6,000) = 34%

See how that’s done? The three balances added together divided by the three credit limits added together equals 34% utilization. This individual is utilizing 34% of all the card credit available to him or her.

Credit Utilization Impact on the FICO Score

FICO actually looks at your credit utilization for each card account individually and for all cards together (as in the example above). The lower your credit utilization in both cases, the higher your FICO score, everything else being equal.

How to Optimize Your Credit Utilization Factor

Optimizing your credit utilization’s impact on your credit score may be a bit trickier than you first think.

For example, paying your balances in full at the end of each month will not necessarily translate to zero credit utilization. Your credit card issuers report your account balance to the credit bureaus at an essentially random time, which may or may not be the period immediately after you’ve paid off your balance. And if you’re like me and pay only the statement balance, you may well have made additional purchases with the card since the statement period ended, in which case your balance won’t be $0 after your payment anyway!

Since you don’t know when your card issuer reports to credit bureaus, the best way to optimize your credit utilization is to always keep your card balance low. If you make a big purchase on your card, nothing says you must wait until the next payment due date to pay off this item. Paying it off right away will help reduce the chance a big balance will be reported.

What about closing credit card accounts? Keeping open a lot of unused credit card accounts is probably a poor idea, but understand closing an account will reduce the total credit available to you by the credit limit on that account, which would then raise your credit utilization, reducing your credit score. You probably don’t want to do something like close a credit card account if you plan to, say, apply for a mortgage or other loan in the near future.

Should you ask for higher credit limits? Higher account limits will reduce your credit utilization, boosting your credit score. But be honest with yourself here: You don’t want to increase a credit limit if you’ll then be inclined to borrow more on that card! That’s called “shooting yourself in the financial foot.”

NEXT: The Payment History FICO score element!

For everything you need to know about managing your FICO credit score, read the Tips sections beginning on page 8 of this free download:

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  • squirrelers

    That’s interesting, how the credit utilization calculation is determined. So if I understand right, even if a person pays his/her balance in full and on time, keeping it unpaid until the due date could potentially hurt since we don’t know on which date the balances are reported to bureaus. I was not aware of that! Not that it would change my behavior any (as I don’t want to be score obsessed), but interesting nonetheless if that’s the case.

    • You’ve got it right. About the best you can do to help assure a big balance is never or rarely reported is to pay off right away–instead of waiting for the due date–big purchases made on the card. Or, a guy could get in the habit of making, say, two payments a month to cut the average balance outstanding at any point in time on a card. But, as you say, this is getting into being obsessive about one’s score, and Americans are already too enamored with credit scores, imho!

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