03 - Your Credit Score Explained

Your three-digit credit score holds incredible power over your financial life, affecting everything from loan rates to insurance premiums. But how is it actually calculated? In this deep dive, we pull back the curtain on the credit score formula, breaking down the five key ingredients that make up your score and revealing which ones matter most. We'll also bust common myths, like why you don't need to carry a credit card balance to build credit, and provide simple, practical habits you can start today to build a positive history.

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Transcript

Episode 3 | Your Credit Score Explained

00:00:00 Shanna Browning: Hey, Daniel, I'm gonna tell you a little story. A friend of mine was recently shopping for a car. He and his neighbor, who have similar jobs and similar incomes, went to the same dealership to buy the same model car. My friend got a loan with a six percent interest rate, but that neighbor got one for nine percent.

00:00:17 Daniel Hill: Wow. What was the reason for the difference?

00:00:21 Shanna Browning: Only difference was their credit scores. My friend has a credit score in the high seven hundreds, but his neighbor was in the low six hundred. That one number was the only thing separating them.

00:00:33 Daniel Hill: And that is a perfect real world example of what we're talking about today. Average credit scores range from three hundred to eight hundred fifty. The lower the credit score, the higher the interest rate. That three percent difference could cost the neighbor thousands of dollars over the time of his loan. Your credit score is one of the most important and most powerful numbers in your financial life. Welcome back to Making Sense of your Cents. I'm Daniel Hill.

00:01:13 Shanna Browning: And I'm Shanna Browning. Today we're going to pull back that curtain on that mysterious three digit number that holds so much influence, your credit score. It can feel like a secret grade that just follows you around, but it's really not as complicated as it seems.

00:01:28 Daniel Hill: It's not a grade on your character or your worth as a person. It's simply a data driven summary of your history as a borrower. Think of it as your personal financial report card. A high score tells lenders you're reliable bet, and they reward that reliability with a better interest rate and better terms.

00:01:48 Shanna Browning: So actually, what goes into that score? It's not a secret formula. And lenders are very transparent about the five key ingredients. But let's start with the most important one.

00:01:58 Daniel Hill: The biggest piece of the pie. Making up about thirty five percent of your score is your payment history. It's a simple question with a huge impact. Do you pay your bills on time? Every single payment -  from your mortgage to your credit card to your student loan. It's all reported to the credit bureaus.

00:02:18 Shanna Browning: So what constitutes a late payment? In the eyes of the credit bureaus.

00:02:23 Daniel Hill: A payment isn't reported as late the day after it's due. It typically has to be at least thirty days past the due date to be reported. But once it is, that one thirty day late payment can cause a significant drop in your score, especially if you have an otherwise pristine record. And that negative mark can stay on your credit report for a full seven years.

00:02:47 Shanna Browning: So what I'm hearing you say is consistency is everything. You can't undo a past late payment. You just have to start building a new long track record of being on time every single time.

00:02:59 Daniel Hill: Exactly. It's the absolute foundation of a healthy score. Now, the second biggest ingredient, at about thirty percent, is your amounts owed, more commonly known as your credit utilization. This mainly applies to your revolving credit, like credit cards and lines of credit.

00:03:18 Shanna Browning: So what's being measured here?

00:03:19 Daniel Hill: It's the amount of credit you're currently using compared to your total credit limit. For example, if you have a single credit card with a ten thousand dollar limit and your statement balance is five thousand, your credit utilization is fifty percent.

00:03:35 Shanna Browning: But being in this banking industry, I've always heard you should keep that utilization below thirty percent. Is that a hard rule?

00:03:42 Daniel Hill: It's a very strong guideline from a lender's perspective. A person who has maxed out all their credit cards is statistically more likely to miss a future payment than someone who is using their credit sparingly. It signals a higher level of financial stress. People with the highest credit scores often keep their overall utilization below, let's say, ten percent. This doesn't mean you can't use your cards. It just means you should aim to pay down the balance before the statement closes to keep that reported number low. So those two habits paying on time and keeping balances low make up nearly two thirds of your entire score. That's huge. Now let's talk about the other three factors.

00:04:25 Shanna Browning: And what's the next biggest piece.

00:04:27 Daniel Hill: Next coming in at fifteen percent is the length of your credit history. Lenders like to see a long, stable track record of responsible borrowing. This factor looks at the average age of all your open accounts, as well as the age of your oldest account.

00:04:43 Shanna Browning: This is why the common advice to cut up all your credit cards and close the accounts can sometimes backfire, right?

00:04:49 Daniel Hill: Exactly. Let's say your very first credit card is one you opened in college fifteen years ago. Even if you don't use it much, that account is an anchor of stability on your report. If you close it, you might erase fifteen years of positive payment history, which can shorten the average age of your accounts and cause your score to dip. It's often better to keep that old. No annual fee card open, even if you just use it for small reoccurring payments once a month to keep it active.

00:05:18 Shanna Browning: And that's a great myth to bust. So what makes up that final twenty percent?

00:05:23 Daniel Hill: The last twenty percent is split evenly between two factors. About ten percent is your credit mix. Lenders like to see that you can responsibly handle different types of credit and installment loan. A car loan or a mortgage has a fixed payment for a set term. Revolving credit, like a credit card, has a variable payment. Having a mix of both shows that you are a versatile and responsible borrower.

00:05:49 Shanna Browning: And the final ten percent.

00:05:50 Daniel Hill: That final ten percent is new credit. This is about how often you apply for new credit. Every time you apply for a loan or a credit card, it typically generates a hard inquiry on your report. One or two inquiries is no big deal, but if you apply for five new credit cards in a month, it can signal to lenders that you might be in financial trouble or taking on too much debt too quickly, which can cause a temporary dip in your score. Shana, let's bust another common myth. Does checking my own credit score lower it?

00:06:24 Shanna Browning: Such a fantastic question. And the answer is a definite no. When you check your own score or your own credit report, it's considered a soft inquiry. You can check it every single day and it will have zero impact on your credit score. It's only when a lender pulls your credit for the purpose of making a lending decision that that counts as a hard inquiry, as you mentioned earlier.

00:06:47 Daniel Hill: So being informed is completely harmless. Another one. Do I need to carry a balance on my credit card from month to month to build my score?

00:06:57 Shanna Browning: Absolutely not. This is one of the most persistent and costly myths out there. You do not need to pay a penny in interest to build a great credit score. The credit bureaus only care that you use the card and you pay that bill on time. Paying your statement balance in full every month is truly the best possible habit for both your credit score and your wallet.

00:07:19 Daniel Hill: So let's bring it all together. If someone wants to improve their score. What are the two most impactful things they can do starting today?

00:07:30 Shanna Browning: So the two most impactful actions are directly tied to the two biggest factors. First, set up automatic payments for at least the minimum amount due on all your bills. This creates a safety net to ensure you are never, ever late. You can always go in and pay more, but the automatic payment guarantees your perfect payment history. And second, focus on your credit utilization. If you have balances on multiple cards, create a plan to aggressively pay them down, perhaps focusing on the card with the high interest rate first.

00:08:06 Daniel Hill: So to recap the five ingredients. Pay your bills on time every time it's thirty five percent. Keep your credit card balances low, about thirty percent. Let your history grow by keeping old accounts open. It's another fifteen percent. Have a healthy mix of credit types ten percent and apply for new credit sparingly. That's the final ten percent.

00:08:33 Shanna Browning: And that formula right there is the formula for success. And it leads directly to this week's actionable tip.

00:08:44 Daniel Hill: Your action item this week is to pull your own credit score. You are legally entitled to a free copy of your full credit report from each of the three major bureaus Equifax, Experian and TransUnion once a year.

00:09:00 Shanna Browning: The only official government authorized site for this is Annualcreditreport.com. This week, don't worry about the three digit score itself. We want you to focus on the raw data in the report. Download your report from at least one of the bureaus and read through it line by line with a highlighter.

00:09:22 Daniel Hill: Look for anything that seems off. Is there an account listed that you don't recognize? That could be a sign of fraud. Is there a payment marked as late that you know you paid on time? Is a credit limit being reported incorrectly, making your utilization seem higher than it is?

00:09:39 Shanna Browning: As Daniel and I have seen in our years, combined of banking, errors are more common than you'd think. Formally disputing an error through the bureau's website is a free process, and is one of the quickest ways to potentially see a significant score improvement. Knowledge is power, and knowing exactly what's in your report is the first step of taking control of your score.

00:10:01 Daniel Hill: Next week we have our first guest. First Century Bank President and CEO Rob Barger will be here to discuss the simple but powerful habit of paying yourself first, which is the key to having money to save and pay down debt.

00:10:16 Shanna Browning: Subscribe so you don't miss it and send your questions to podcast@fcbtn.com. As always, thanks for listening.