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The fourth factor in the credit scoring model has to do with having a fair mix of credit. 

10% OF YOUR CREDIT SCORE IS DETERMINED BY THE TYPES OF CREDIT THAT YOU HAVE.  

Unfortunately, the credit bureaus are rather vague about exactly how many of each type is ideal, but it’s safe to say that having too many revolving or too many installment accounts can cause the score to drop.  Installment accounts, such as car loans and mortgages, can have a positive effect on the credit score even after they are closed, whereas revolving accounts, such as credit cards and consumer finance accounts, usually stop impacting the score once the accounts are closed.  Also, the credit bureaus tend to value installment loans higher since creditors tend to require more documentation for these loans, such as proof of income, assets and a more in-depth analysis of debt-to-income ratios. 

Also, major credit cards, such as Mastercard, Visa, American Express and Discover, tend to have a higher score value than department store or other finance company cards.  Consumers who are looking to establish credit should consider getting a secured credit card that is issued by one of the four major credit card issuers instead of applying for a department store credit card.  Many department stores will not even grant an approval unless you have at least one major credit card. 

Having a fair mix of credit can help to optimize your score, but it should not be your only consideration.  If you read the first three parts of this series, then you already know that payment history and account balances make up the majority of the scoring factors.  So worry about those more, especially if you are just establishing or rebuilding your credit. 

So far we’ve covered four of the five factors that make up credit scores:

Payment History – 35%

Account Balances – 30%

Length of Credit History -15%

Types of Credit – 10%

These four factors make up a total of 90% of your credit score.  The final factor, new credit, makes up the last 10% of your score, which I discuss in detail in Part 5 of this series.

So after payment history and the amounts owed on accounts, the third factor looks more at how long a person has been creditworthy. 

15% OF YOUR CREDIT SCORE  IS DETERMINED BY HOW LONG YOU’VE HAD CREDIT ESTABLISHED. 

This doesn’t mean how long you’ve had an actual credit report on file with the bureaus.  The majority of people have had some kind of credit file since they were 18, so that would effectively amount to age discrimination if it were that simple.  This factor looks at two main sub-factors: The average age of your accounts and also the age of your oldest account on your credit report.

The age of the oldest open account is something that people often overlook as being an important part of their credit score, and is also something that people can easily sabotage without ever realizing they are doing harm to their score.  Often times, consumers run up rather large balances on accounts, such as credit cards, and may struggle for a long time to pay them off completely.  When this happens, people are often elated and will sometimes close the account (or multiple accounts) to keep themselves from ever charging it back up again. 

While this may be a good form of financial self-discipline, it’s also a good way to drop your credit score by a substantial amount of points very quickly.  Instead of closing the account, try cutting up the actual credit card if you are worried you might be tempted to use it.  This will eliminate your ability to use the card most places, since the magnetic strip will be destroyed and other info, such as the expiration date and the three digit card security code. 

The other factor, the average age of accounts, is affected whenever new accounts are opened or old accounts are closed.  The effect of opening new accounts can be disheartening, but your credit score will eventually go back up within a few months as long as you keep the balances low and make all of your payments on time. 

The age of your accounts is important, and it’s a good reason why people with bad credit or no credit should consider getting a secured credit card to establish a credit history.  The sooner you take the initiative to start rebuilding your credit, the sooner your credit score will get to a point where you can obtain competitive interest rates. 

The spread (difference) between rates for good credit borrowers and rates for those with less than perfect credit is increasing dramatically because of the fiancial crisis.  So the long term cost of having bad credit is increasing, despite the fact that interest rates are actually dropping.

So now we’ve covered three of the five factors that make up your credit score:

Payment history – 35%

Account Balances – 30%

Length of Credit History – 15%

These three factors make up 80% of your credit score.  Obviously they are the most important ones, but two other factors are also considered that have a smaller but yet important impact.  Now check out Part 4 of this series, which discusses the types of credit used.

The next most important factor in credit scoring is the balances on your accounts. 

ACCOUNT BALANCES MAKE UP 30% OF YOUR CREDIT SCORE. 

And as with payment history, there are many different facets to this factor.  For example. the total amount owed on all accounts is considered, but so are the individual account balances relative to their credit limits, or the “high balance” on each account.  This is particularly important on revolving accounts, such as credit cards.  The scoring model compares your account balances to the credit limits.  Whenever the balance exceeds 50% of the credit limit, this can lower the score, often by quite a bit.  You might be surprised how much your score would increase if you just paid down all of your credit cards to 50% or below their respective credit limits.

One misconception consumers often have is that paying off their credit cards every month means that their score will never drop because of high, or carried, credit card balances.  This is actually not true because most companies only report to the credit bureaus once a month, and it’s often at a time when the balance is at its highest.  Every company reports at different times, and individual companies may report different accounts on different days of the month.  It’s very confusing, and there’s usually no way to know for sure without asking your card issuer.  And chances are if you call them, there’s a good chance they won’t even be able to tell you.

For example, let’s assume you have a credit card with a $1000 balance.  Each month, you charge approximately $800 in expenses.  Even though you pay the full balance each month, the credit bureaus will probably show an $800 balance at any given time, depending on how fast you charge up the balance and also what day of the month they report to the credit bureaus.  So the smart thing to do would be to start using another credit card once the balance got close to $500.  Or you could ask the credit card issuer to raise your credit limit to $1700 so there would be little chance you would exceed that 50% threshold. 

Consumers looking to qualify for a mortgage in the near future should take the time to analyze their revolving accounts and try to pay down the ones with the smallest balances first to below 50% of their credit limits.  This is one of the easiest ways to optimize your credit score very quickly (assuming you have the extra cash to do that, of course). 

Credit card and revolving account balances seem to have the most profound impact on credit scores.  Other balances, such as mortgages and car loans are definitely considered as well, but the credit bureaus realize that having a high mortgage balance in and of itself doesn’t necessarily make someone a higher credit risk.  But high balances on credit cards can definitely indicate a problem, especially if there are multiple accounts that are over 50% of their credit limits.  The closer you get to maxing them out, the lower your score will drop as well.  So take the steps to optimize your score and keep your balances low.  Credit cards should never be used to pay for things you can’t afford because the compound interest will enslave you to debt for many years if you’re not careful.  But credit cards provide many useful consumer benefits that can be very helpful and valuable if used in a responsible manner.

So far, we’ve covered two of the five factors of credit scoring:

Payment History – 35%

Account Balances – 30%

Just these two factors alone make up 65% of your credit score.  The last three make up just 35% of the score, but they are still very important.  Check out Part 3, which talks about the length of credit history.

Every consumer should be aware of what factors determine their credit score.  Credit scores are determined by a complex mathematical formula, known as an “algorithm”.  As complex as this formula may be, the important thing to understand is that the credit bureaus have told us there are FIVE MAIN FACTORS that determine credit scores. 

Part 1 of this blog series will focus on the largest piece of the credit scoring pie – Payment History.  It only seems fitting that payment history is the #1 factor that determines credit scores since they are meant to predict the likelihood of a borrower repaying a loan. 

PAYMENT HISTORY MAKES UP A TOTAL OF 35% OF THE CREDIT SCORE.

The payment history on accounts is kept for a total of seven years.  There are three main “sub factors” within the factor of payment history that the credit bureaus analyze, which are:

• How RECENT were the late payments.  A popular misconception among consumers is that late payments cause an equal amount of damage for seven years since that’s how long they stay on the credit report.  Although they do remain for seven years, the effect greatly diminishes over time.  Late payments in the last one year make up approximately 40% of the negative factor in this part of the scoring process.  Late payments 1-2 years old make up about 30%, 2-3 years old make up about 20% and over three years old only account for about 10%.  So one late payment might indeed have a rather shocking impact on your credit score, but as time goes on, the impact of this late payment will diminish.
• The FREQUENCY of late payments.  Having one isolated late payment on one account can often just indicate that a bill was lost in the mail, or even that a creditor made a mistake in crediting the payment.  One late payment will, indeed, lower your credit score, but when late payments become a frequent occurance, this indicates more of a problem, especially if there are late payments on multiple accounts.  Late payments on multiple accounts at the same time is often a clear indicator of a financial hardship that may greatly impact a person’s ability to take on new credit, which is what the credit scoring system is designed to look for.
• The SEVERITY of late payments.  The credit bureaus do not record a late payment until an account is actually 30 days late.  So if you’re 10 or 15 days late paying a bill, the account may show past due if a credit report is pulled during this period, but no record will exist with the bureaus after the account is brought current.  (YOU MAY, however, BE CHARGED A LATE FEE if the payment is JUST ONE DAY LATE, depending on the creditor’s terms).  However, once the 30 day mark hits, a record of the late payment is shown as a “30 day late”.  If the account goes 60 days late, a record of a “60 day late” is recorded.  And so forth and so on.  Late payments are categorized in terms of severity in 30 day incriments all the way up to 150 days late (5 months).  The longer the payment is delinquent, the worse this will impact the credit score.

Payment history is essential to determine whether a consumer is capable of repaying a debt and repaying that debt on time.  Late payments cost lenders money, and they would rather have a customer that pays on time instead of having to resort to collection efforts.  This is why credit scoring exists-to give lenders a statistical model that determines the likelihood that they will repay their debts. 

Although this is the most important factor in credit scoring, it’s far from the only factor.  And it’s important to remember that a perfect payment history doesn’t translate into a “perfect” credit score either.  There’s no quick fix to achieve a good credit score, but maintaining a good payment history is key to keeping a score that’s acceptable to most lenders, including mortgage lenders.  And the more recent, frequent and severe these late payments occur, the more impact they will have on the credit score.

Check out Part 2 of this blog series, which discusses what factor account balances have on the credit score.  They are almost as important as payment history, and there are many ways to increase your credit score by following certain rules about balances.