Credit Score Explained
Credit is one of those things that everyone seems to have an opinion about but most people don’t actually know how it works… kind of like politics. If you’ve been keeping up with my posts, you’ll know that I firmly believe money is the foundation of freedom. Your credit score plays a big part in that freedom. Having good credit gives you the flexibility to borrow money, which can in turn improve your cash flow. See my post on how I created passive income by getting a mortgage here and you’ll get what I’m saying.
Let’s start with the basics.
The system is, in a way, set up for you to fail. I know, not the most promising way to start off but that’s why it’s so important to understand how it works. Once you do, you can use it to your advantage.
It’s no secret that millions of Americans are in serious debt. The easy solution would be to stop using credit cards. However, if you stop using credit cards, then you won’t have a good credit score, which means you can’t take out a mortgage or loans. (Disclaimer: credit cards are not the only way to build credit, just the easiest and most stable). The system is essentially forcing you to go into debt in order to be allowed to take out loans to go into even more debt.
So, how do we avoid this vicious cycle? Well it’s pretty easy. Get a credit card, use it for all the purchases you’re making anyways, and pay it off in full and on time each month. That’s basically the key to getting a high credit score. If that sounds too easy, then someone probably tried to convince you one of the following statements, which are absolutely not true:
You need to carry a balance to build your credit.
You only need to pay off the minimum balance each month.
Credit cards are the devil’s work and you should never use them!
So, now that you understand the basics of what credit is and how to build it, let’s move on.
How your credit score is calculated
Payment History – 35%
35% of your credit score is based on your payment history. Basically, did you pay your bills in full and on time each month? This portion is the largest factor of your score because it shows lenders if they will get their money back should they choose to approve you for a loan. So, what happens if you had some sort of emergency that your savings didn’t cover and you had to use your credit card? In this case, you should at least pay the minimum balance so it will count as an on-time payment. You’ll still have to pay interest on what you couldn’t pay, but at least it won’t be considered late.
Utilization – 30%
30% of your score is based on how much of your available credit that you actually spend. Credit bureaus are looking at the percentage of your total available credit that you utilize. The magic number is 30% (or less). So, if your credit card has a limit of $5000 per month, you’ll only want to spend $1500 a month, at the most.
Length of Credit History – 15%
The length of your credit history, which accounts for 15% of your score, is pretty self-explanatory. It’s how long you have had some type of credit, whether it be a credit card, car loan, etc. Don’t worry too much about this since there’s really not too much you can do except, well, keep on living. Other than that, the only thing you can really do is to keep your first credit card for as long as possible.
Credit Mix – 10%
Your credit mix is all of the different types of credit that you have. This is another way the system sets people up for failure. They want you to have a credit card, and a car loan, and a mortgage, as all different kinds of debt to pay off, to show you’re responsible. The good news, is that this only allots for 10% of your score. Before my mortgage, I only had credit cards and my score was 700+, so it’s definitely possible to avoid several different loans just for the sake of building your credit.
New Credit – 10%
New credit, accounting for a whopping 10% of your score, refers to any accounts that have been opened recently. Basically, the credit bureaus don’t want you to open several new credit cards in a short period of time. They see it as reckless and irresponsible, therefore lowering your score. As long as you’re not applying for 5 credit cards a month, you should be fine.
The bottom line…
The bottom line is that you need credit if you ever plan on getting a mortgage or loan, which could aid in creating passive income, like it did for me. Focus on the payment history and utilization portions of your credit score and you should have no problem getting up to 700 and beyond.
Still have questions on credit scores? Leave a comment below or email me at firstname.lastname@example.org.