How Credit Scores Really Work

One topic that I think a lot of people misunderstand is how credit scores work. While most people understand the basics of credit scores, I don’t think most people truly understand how the different credit score factors actually impact their score.

In this post, I want to go over all the different factors that make up your credit score. I think the most important takeaway you can have from this post is that opening and closing credit cards will not generally hurt your credit score – not in the long run, at least, and certainly not enough for it to impact your ability to get more credit cards so long as you’re always paying your bills on time.

Credit Scores – FICO Vs. VantageScore

At the outset, it’s important to remember that credit scores are a private creation (i.e. not something created by the government). The score most people will be familiar with comes from a company called FICO, which uses various factors (more on those factors later) to calculate your credit score.

You may also notice that some credit score apps like Credit Karma and Credit Sesame will give you a credit score from a company called VantageScore. While VantageScore uses the same factors as FICO and can give you a general idea of what your FICO credit score is, no bank uses a VantageScore credit score, so, for the most part, you can ignore your VantageScore, especially since there are plenty of banks that will provide you with your FICO score. For the purposes of this post, the only score we care about is your FICO credit score.

Credit Bureaus

To make things a bit more complicated, your credit score is based on information that comes from three different credit bureaus – Experian, Equifax, and TransUnion. All three credit bureaus will have slightly different information about your credit history and calculate your score a little differently, so your score will vary slightly between the three bureaus.

Different banks will also pull your credit report from different credit bureaus; thus, the main difference in your credit report between the different bureaus will usually be your hard pulls (more on that later in this post). For me, the banks I tend to get cards from typically pull from Experian or Equifax, with fewer pulling from TransUnion. As a result, my TransUnion credit report usually has the fewest hard pulls, while my Experian and Equifax reports typically have more hard pulls.

Credit Score Factors

Your FICO credit score is based on five factors. In this section, we’ll look at all five factors that make up your credit score and how they work.

1. Payment History

By far the most important aspect of your credit report is your payment history. This goes without saying – if you don’t pay your credit cards and other bills on time, your credit score will suffer.

The rule here is pretty simple – always pay your bills on time. Banks and other financial institutions can report late payments that are 30 or more days late, and even one late payment can drastically drop your credit score. I recommend setting up auto-pay on all of your accounts, but you should also keep an eye on your accounts to make sure that the auto-payments continue working.

Indeed, I recently experienced an issue that significantly impacted my credit score and will continue to impact my credit score for years to come. I have a Bank of America credit card that I rarely use, which has been set on autopay for nearly a decade, with the only charge on it being a small monthly Apple subscription. For some reason, Bank of America randomly turned off my autopay, resulting in two months of missed payments. Since this isn’t a credit card that I regularly use, I didn’t notice the missed payments. After two months of missed payments, Bank of America reported this late payment to the credit agencies as a 30-day late payment, resulting in my credit score dropping by around 75 points!

Fortunately, I already have a high credit score, so this single late payment on my credit report hasn’t impacted my ability to get new credit cards. However, this late payment will stay on my credit report for 7 years, and it likely means I’ll never get my credit score back to the level it was once at (previously I had an 850+ credit score, now I’m down into the 750 to 790 range).

Long story short, make sure you always pay your bills on time, and even if you have something set on autopay, you might want to check it every once in a while.

2. Credit Utilization

Credit utilization is the second most important factor of your credit score, so it’s important to understand how it works. Credit utilization refers to the total amount of available credit you’re currently using. There are two parts to your credit utilization: (1) your total credit utilization, and (2) your credit utilization on each individual credit card account.

Your total credit utilization has to do with the total credit being used among all of your credit accounts. For example, if you have three credit cards with a total of $10,000 of available credit between them, and you have a $2,000 balance on one of your cards, your total credit utilization would be 20%.

In addition to total credit utilization, there is also individual credit utilization. Using the same example above, if one of your credit cards has a $3,000 credit limit and you currently have a $2,000 balance on it, that would give you an individual credit utilization on that card of 66%.

Your aim with credit utilization is to keep both your total credit utilization and individual credit utilization on each card to under 10%, but ideally, to 5% or lower. The thing to know about credit utilization is that it can dramatically impact your credit score month to month, but can also be easily fixed simply by paying down balances before they’re reported to the credit agencies.

One interesting thing about credit utilization is that having a high credit utilization on any individual card will dramatically hurt your credit score. For example, if you have a 90% or 100% credit utilization on a single card, it has the same impact on your credit score as a missed payment (i.e. your score can drop by 50 or more points just by having one card with a very high credit utilization).

That being said, while a high credit utilization can hurt your credit score, any impact on your credit score is also temporary so long as you pay your balances down. When your credit score is impacted by a high credit utilization will also depend on when your bank reports your balances to the respective credit agencies. So, while you might have a high balance on one of your credit cards at some point, it won’t really matter if it’s not reported to the credit agency by the time you pay it down.

3. Length of Credit History

Your length of credit history makes up 15% of your credit score and is a factor that I find a lot of people misunderstand. Length of credit history is calculated based on the average age of all your credit accounts. The older your average age of credit is, the better it is for your credit score. Anytime you open a new personal credit card, you’ll notice your average age of accounts will drop slightly, since any new credit accounts you open will start with a credit age of 0.

As a general strategy, it’s best to keep older cards active if you can, so that your average age of accounts can stay high. My recommendation is to have several no-annual-fee cards that you keep open forever. Those will form a nice base for you when it comes to your average credit age.

Closing cards is something that definitely confuses a lot of people, as I find many people don’t understand what closing a card does to your average age of accounts. Most people assume that when you close a card, it’s removed from your credit report, but that isn’t what actually happens. Instead, your closed account stays on your credit report for 10 years, continuing to age over those 10 years. After 10 years, the account is then removed from your credit report.

As a practical matter, what this means is that closing a credit card doesn’t hurt your average age of accounts. This is because the account, while still closed, will continue to age over the next 10 years before being removed from your credit report. That means you can have cards that have been closed for years, but they’ll still be several years old, actually improving your average age of accounts until they eventually drop off your credit report in 10 years. By then, all of the older cards you still have will have aged another 10 years, so the impact of losing those aged, closed accounts won’t matter.

In short, closing credit cards isn’t something to be very concerned about and won’t hurt your credit score over the long run.

4. Credit Mix

Credit mix only accounts for 10% of your credit score and refers to the different types of credit that you have. In general, having different types of credit accounts will help your credit score. Credit cards, for instance, are considered revolving credit. Student loans are a different type of credit. And a mortgage is another type of credit. Having a mix of different credit accounts is beneficial.

That being said, this is not a factor that matters much, so do not take out different types of credit simply to improve this factor. It’s completely okay to have a credit report that only consists of credit cards and doesn’t include other types of credit.

5. New Credit Inquiries

The final component of your FICO credit score is new credit inquiries. Most of the time, when you apply for a new credit card, you’ll get a “hard pull” on your credit report, which means the bank officially looks at your credit report. Every hard pull you get will lower your credit score by a few points. However, the effect is fairly temporary, and while hard pulls stay on your credit report for two years, they have little effect on your credit score after a few months and no effect at all on your credit score after a year.

There are two things to know about credit inquiries. First, only hard pulls will appear on your credit report and impact your credit score. Banks and other financial institutions will often do “soft pulls” as well, where they look at your credit report, but don’t officially look at it with a hard pull. A soft pull has no impact on your credit score and does not appear on your credit report.

Second, most banks don’t do a hard pull from every credit bureau. Rather, they only do a hard pull on one or two credit bureaus. So a bank might pull only from Equifax, while not doing a hard pull on your TransUnion or Experian credit reports. This is a good thing because you can spread out your hard pulls between different credit reports if you open new cards with different banks.

Final Thoughts

For the most part, opening and closing new credit cards isn’t something to worry about when it comes to your credit score. So long as you’re always paying your bills on time, you’ll find that opening new cards and playing the travel rewards game will often increase your credit score. Indeed, my credit score (until this recent accidental late payment happened) was the highest it has ever been, even as I have been opening and closing multiple credit cards every year.

I hope this gives you a decent background as to how credit scores work. If you have any questions, feel free to ask in the comments and I’ll answer them as best as I can.