Complex Numbers

Credit Where Credit Is Due

This article is more than two years old now, but nothing's really changed about its subject matter (even as everything else has).

How Your Credit Score Is Calculated  
Here's the formula for success no matter which model lenders use.

I'm linking this because there is a great deal of false, including dangerously false, information out there on the subject.

As a side note, this one's only going to be applicable to US readers. I have no idea how other countries do this sort of thing.

Your credit score—the three-digit number that creditors use to evaluate the risk when they lend you money—helps determine which loans or interest rates you qualify for and how much you’ll pay. Landlords, utilities and cell-phone companies may also check your score before doing business with you.

This may seem unfair, but it's a much fairer system than "Sure, I'll lend you money; you look like a fine, upstanding white man."

Both grade your creditworthiness on a scale of 300 to 850, with a score of 750 or above generally considered good enough to qualify for the best rates.

One thing that all of these scores have in common is that they don't share their exact methodology used for calculation. Still, there are some things that we know, and this article goes into them.

On-time payments. Both FICO and VantageScore prize on-time payments above any other factor. As long as you pay at least the minimum due each month, your payment history will stay clean (though you will rack up interest on your balance).

The best way to handle revolving credit is to pay off the entire balance every month -- effectively, use it as a debit card. Some people don't have the discipline for this, though, and that's something that it's good to know about yourself. One falsehood I heard is that you *have* to carry a balance; this is utter tripe.

Every credit card I know provides a grace period before charging interest. A balance that is paid off in full, on time, shows up as credit use on the reports, because the scoring people check it at some interval. You can make a charge on, say, November 1, which doesn't show up on the statement until November 20, and that statement is due on, say, December 15 -- effectively an interest-free loan for a month and a half.

Miss a payment, though, and you're in danger of lowering your credit score -- not to mention incurring penalty interest charges, which are usurious. Pay only the minimum payment on time, and there's no effect on the score, but then you start incurring regular interest charges, which are usually just shy of usurious.

But in a pinch, at least make the minimum payment if you care about your credit score.

Limits on your credit usage. Your credit utilization ratio is the amount you owe on your credit cards as a proportion of the total limit on each card, as well as the total limit for all of your cards in aggregate. VantageScore advises consumers to keep their utilization ratios below 30%, but “the lower the better,” says Barry Paperno...

Now, I'm not 100% sure about this, but my understanding is that, unlike with late payments, a ding to your score doesn't hang around very long after you have a high utilization rate once.

Still, as the article suggests, it's better to have a low utilization rate than a nonexistent one. Some people think their credit must be fine if they don't have any balances or don't use credit. Nothing could be further from the truth; this is like saying your muscles must be fine even though you don't exercise.

There are, of course, people who choose to avoid credit altogether. That's a valid choice. Just know that this could limit your options, if, say, you try to rent somewhere that does credit checks.

A long track record. This slice of your score considers the age of your oldest account and the average age of all your accounts.

Unfortunately, this is just one of those things that takes time to build up. Fortunately, it's not a huge percentage of your score. Some people get tempted to close older credit cards they haven't used in a while; this may be a good idea if said account charges an annual fee, but there's a card I've had since the early noughties, with no fee, that I remind myself to use on just a small purchase every year -- because I've had issuers cancel cards on me that I don't use.

Why did I apply for them if I don't use them? Well, for a while there, they had promotional things -- like, spend $2000 in three months and you get $100 cash back sort of thing. They had no fee, and the cards were otherwise useless to me, so I met the minimum, paid it off every month to ensure I wouldn't get an interest charge, and then stopped using the card once I got the $100 check. It was a free $100. Who doesn't want a free $100?

(I think they all told each other about my one weird trick, because I don't get those cherry deals anymore.)

Other factors. A mix of revolving and installment loans also boosts your score. But don’t overdo it when applying for new credit.

This is one thing that keeps my credit score from being perfect; I no longer have a mortgage or auto loan. And the small difference it makes -- 10% of the total score -- is in no way worth the interest I'd pay, even though mortgage and auto loans tend to be much lower interest than credit cards or other revolving accounts.

Every once in a while, I get 0% financing offers, for example, I had to replace my home's HVAC unit a few years ago. That sort of thing usually counts as an installment loan, but some companies run it through their credit card, which makes it just another revolving credit account. If you go for 0% financing, though, make damn sure you never miss a payment -- because the 0% is usually contingent on paying the entire installment, on time, every month. Depends on the terms, of course, but in general, miss one and you end up paying a lot more than you were quoted.

And with cars, e.g., sometimes you get a choice: 0% financing, or some amount of cash back. Say it's $2000 for the sake of discussion. Take your car price and subtract $2000 -- the result is the actual cost of the vehicle, and the $2000 represents interest. That may or may not be worth it, depending on the terms and your own situation, as well as what interest rate that $2000 comes to, amortized over the rate of the loan, and compared to the standard interest rates for an auto loan. Fair warning, though: that will involve math.

Most people are better off paying less money for a used car, anyway.

Having “hard inquiries” on your credit report from potential lenders will temporarily shave points from your score.

Which is one reason it's a bad idea to open a bunch of credit cards in a short span, even if they're offering the free $100 or whatever. But, again -- not a big factor. The biggest factors, by far, as presented in the article, are on-time payments and low utilization rate.

One of these days, maybe I'll tackle misinformation about taxes, for instance, why that refund check is a Bad Thing. But enough for now.