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Understanding Credit Scores

December 03, 2008 December 03, 2008

As the economy continues down its volatile path, keeping a watchful eye on your credit score is more important than ever. But simply watching your credit score isn't enough. You have to understand how credit scores work and how using your credit can affect them. This is easier said than done.

Understanding how credit scores work is complicated. When you apply for credit, increase a credit line or make a late payment—all these things can affect your score. And to make it even more complicated, these actions have different effects on lower credit scores than they do on higher ones.

To better illustrate the point, let's look at some actual credit scores* and see how "credit events" can affect each differently. For obvious reasons of privacy, let's just call them "Jane and John Doe." Jane has always been great with her money and how she uses credit. Her score is 793. John, on the other hand, has had some trouble in the past with how he deals with money. His score is only 576.

Getting a New Credit Card — Jane 793 to 791, -2 points. John 576 to 557, -19 points.

Let's start by looking at what happens to the Does' credit when they add a new card with a $15,000 limit to what they already have. In Jane's case, she already has several credit cards and adding a new one barely changes her score, but not so for poor John. If John could even qualify for a new card, it will cost him 19 points against his credit.

Increase Credit Limit of Credit Cards by $10,000 — Jane 793 no change. John 576 to 612, +36 points.

Jane already has several credit card accounts, so increasing her credit limit by $10,000 doesn't change her score because her credit card utilization is already 0%. As for John, the extra $10,000 in credit line lowers his credit card utilization significantly and therefore boosts his score by 36 points!

Closing Oldest Account — Jane 793 no change. John 576 to 558, -18 points.

Established credit accounts are great for showing credit history and adding numbers to your score. For Jane, who has a long line of established credit, closing an old account has little or no effect. But for John the results are damaging. Closing his oldest account costs him 18 points because he loses any good credit attached to it. And it doesn't work both ways. If you close an account with a mediocre history. that history

stays with your credit score.

Paying Off All Credit Card Debt — Jane 793 no change. John 576 to 615, +39 points.

Jane always, always pays off her credit card debt and carries no balance on her cards. This doesn't change a thing for her. But for John, it's a big benefit. Paying off all of his credit card debt raises his score by 39 big points and goes a long way to establishing good credit.

Increase Credit Card Debt by $10,000 — Jane 793 to 769, -24. John 576 to 556, -20 points.

This is where Jane's good habits actually hurt her score more than John's. By increasing her credit card debt by $10,000, her score drops more than John's because she had no debt prior to the $10,000, whereas John has some preexisting debt.

Allow 1 Monthly Account To Become 30 Day Past Due — Jane 793 to 759, -34. John 576 to 558, -18 points.

Poor Jane, she's had a bad month or two and misses her first monthly payment. For John, this is old school. This will hurt Jane more than John because a 30-day delinquency for someone with no prior problems is an early warning of default risk and changes her score by -34 points, almost double the points that John will lose.

Have On-Time Credit History for 24 Months — Jane 793 no change. John 576 to 595, +19 points.

This is John's moment to shine. By paying his bills on time for 24 months he can increase his credit score by 19 points. Paying bills on time for 24 months does not affect Jane's score because she has paid her bills on time for over 10 years, establishing a great credit rating.

Credit and credit scores have always been cryptic and difficult for consumers to understand. Whether you're like Jane or John Doe, it's important to get control of your credit, especially in these days of economic uncertainty. Hopefully by demystifying the information, you can see how using credit wisely can go a long way toward building your financial health.

The credit score changes in this article are based on Credit Karma's personalized credit simulator and are not guaranteed to occur.

Disclaimer: All information posted to this site was accurate at the time of its initial publication. Efforts have been made to keep the content up to date and accurate. However, Credit Karma does not make any guarantees about the accuracy or completeness of the information provided. For complete details of any products mentioned, visit bank or issuer website.

Category: Credit

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