Your credit score can affect many aspects of your financial life.
The three main credit reporting agencies, Equifax®, TransUnion®, and Experian™, create and generate your credit reports. You credit score is a number, typically ranging between 300 and 850, that indicates how likely you are to repay your debts. The three major credit reporting agencies calculate your scores based on their own models, but these are not the scores that most lenders are looking for. There are several independent scoring companies, each with its own model for how they convert your credit report information into a score that indicates the level of risk that you may default to a creditor. Today, a vast majority of major lenders use the FICO® Score, a credit score created by the Fair Isaac Corporation, when making decisions on whether to lend to you. The score holds so much weight that it can affect the interest rates that you may pay on loans, your insurance rates, and even your ability to rent a home.
Understanding your credit report and how your credit score is compiled is a good place to start. Let’s break down your FICO® Score, as it is currently the most widely used credit score format that the top lenders are using.
The Fair Isaac Company considers five categories when calculating your FICO® Score: your payment history, how much you owe, your length of credit history, the credit mix that you keep, and your new accounts.
Your payment history (35%) — Thirty five percent of your FICO® Score comes from how you have managed your past payments to your creditors. This section of the reporting will take into consideration the payments you have made to creditors. Creditors, including credit cards, retail accounts, installment loans, auto and mortgage loans and many others, report to the major credit reporting agencies and that information is used to tabulate your score. To maintain, improve and build your credit score, it is important to make your payments on time every time. This keeps your accounts in good standing and helps create more depth in your payment history.
Missing payments or making payments late will have a negative effect on your score. The more frequent the missed or late payments are, the greater the impact they will have to your overall score. Public records and collection accounts, such as bankruptcies, tax liens and civic judgements, can lower your rating in this category dramatically and can have serious long-term repercussions on your overall score.
Your payment history is the section given the most consideration in determining your score, and it is the most important factor a lender assesses when determining the level of risk it will undertake when issuing you credit.
Amounts Owed (30%) — Thirty percent of your score is based on how much you owe your creditors. There are several factors that come into play in the amounts-owed part of the scoring. Simply owing money does not always negatively affect you score, though when your credit utilization ratio (the total dollar amount of revolving credit, usually credit cards and personal lines of credit, you currently owe divided by the total available credit limits of the accounts) is high, it can indicate that you are overextended and are more likely to default if you come into a financial hardship.
For example if you have on credit card with a limit of $10,000 and owe $6,500 on that card you would have a credit utilization ration of sixty five percent. The higher your credit utilization ratio the great the impact it will have on your overall score. A good rule of thumb is to have a credit utilization ratio of thirty percent or lower.
Length of credit history (15%) — You can still have a high credit score if you haven’t had a long history of credit, but you’re doing well on all the other categories. Your length of credit history makes up fifteen percent of your total score. Typically, the longer you have had credit accounts the more positively this will impact your overall score. The average time that each of your accounts has been open will help to determine your overall length of credit history. Having a longer credit history provides more information to base lending decisions on for potential lenders.
Credit Mix (10%) — When it comes to credit mix, think about diversity. Having a variety of types of credit accounts can have a positive effect on your credit score. It is not necessary to have every type of credit account available, but a few different types of credit will show that you can manage a mix of account types. It will be okay if you are just starting out or do not have a variety of forms of credit. Your credit mix is ten percent of your combined FICO® Score.
New Credit (10%) – Last but not least, the final ten percent of your FICO® Score is made up by evaluating your new accounts and account inquiries. It has been shown that opening numerous new accounts in a short period of time can indicate a financial problem and may indicate a greater likelihood of future default. It is not just a new credit account that will impact you but also the credit inquiries. When you are shopping for new credit, the lender will report an inquiry regardless of whether they issue credit. These inquires will remain on your credit report for the next two years and can negatively affect your credit score for the next year. Consider this whenever seeking to obtain new credit.
Knowing more about how your credit score is calculated can help you maintain or build a better score. Think of your credit score as a way of explaining your combined history of credit to a lender who knows nothing about you. Your credit score is simply a risk score, a risk of how likely you are to repay a lender. The higher the score the more likely you are to repay them. A lower score may indicate the opposite, and this can make it more costly for you to borrow money (riskier loans charge higher interest rates). Having a higher credit score can help you save thousands of dollars over the course of your lifetime.
In the case of credit scores, knowledge can be power. Tell me your stories and your thoughts by leaving a comment below. Let’s have a better money conversation.