Hello Neighbors,

This month, I have decided to focus on the topic of credit, what makes up your credit score, and some myths we can debunk.

Credit is essentially trust — the lender’s belief that you will repay what you borrow. A positive credit history signals reliability, which can lead to better interest rates on mortgages, car loans, and credit cards, while credit hiccups may raise rates. Today, your history can even influence job prospects. A common metric for evaluating this trustworthiness is your credit score.

Credit scores provide a numerical value indicating how well you have repaid past debts. Unfortunately, this score does not take into account a person’s individual circumstances that may have led to any repayment issues. There are two credit score models, VantageScore and FICO, and they range from 300 to 850. The most commonly used model is FICO.

A person’s credit score is based on five factors: payment history, credit utilization, length of credit history, new credit, and credit mix. The biggest factor is “payment history,” which accounts for 35% of your credit score. This is affected by whether you have missed any payments and, especially, whether any accounts have been sent to collections.

The second-biggest factor is “credit utilization,” which affects 30% of your score. This is determined by how much credit you are using across your accounts. For example, if you have a credit card with a $1,000 limit and a balance of $100, you have 10% credit utilization. It is highly suggested that a person keep their credit utilization at 30% or lower across all accounts, with a 10% ratio being particularly strong.

Next is “length of credit,” accounting for 15% of your score. For this factor, the longer your credit history, the better. To that end, try not to close your oldest credit card, even if you do not use it. After length comes “new credit,” which makes up 10% of your credit score. This reflects how many credit accounts you have opened recently. Opening new credit accounts in a short amount of time can temporarily decrease your score. This drop slowly goes away and should disappear completely within 24 months.

The final 10% of your credit score is based on your “credit mix.” This mix consists of your variety of credit, including auto loans, mortgages, credit cards, personal loans, and more. Now that you know what makes up your credit score, let’s tackle some credit myths.

Perhaps the most notorious credit myth is that keeping a credit card balance is beneficial to your score; this is not true. Not only does carrying a credit card balance result in interest being added to your balance, which you can avoid by paying it in full each month, but carrying a balance also increases your credit utilization ratio. So, carrying a balance costs you money and can actually decrease your credit score by driving up your utilization.

Another pervasive credit myth is that missed or late payments stay on your credit report forever. This is also not true. For the most part, missed or late payments remain on your credit report for up to seven years, after which they drop off. Also, the older the instance of a missed or late payment gets, the less effect it has on your score — a missed payment from five years ago will affect your score less than a late payment from one year ago.

A final myth is that checking your credit score can hurt it. This is only partially true. There are “hard” inquiries and “soft” inquiries. A hard inquiry is when a lender formally pulls your credit report and score to determine if you meet their lending requirements; this type of inquiry can affect your score for a time. Soft inquiries, on the other hand, do not affect your score. A soft inquiry occurs when you check your own credit or when a creditor that monitors your score, such as a credit card servicer, provides it to you for free through an online portal.

So, applying for a loan triggers a hard inquiry and can affect your score, while checking your score through your online bank or an existing credit card platform is a soft inquiry and does not affect it.

Credit, scores, and reports are fascinating and detailed topics. We will continue to examine them in the months to come, exploring how to grow your credit, how to bounce back from setbacks, and what a credit report is — including how to get your own free copy up to three times a year.

If you have any questions related to personal finance or suggestions for topics you’d like this column to explore, feel free to email me at MasonFinancialAdvising@gmail.com.

Currently Reading: “A Random Walk Down Wall Street” by Burton G. Malkiel

Andrew Mason, MBA, AFC Candidate

Disclaimer: This column is for educational purposes only and does not constitute financial advice.