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How to Understand your Credit Score

According to the American Bankers Association, about half of all consumers know what their credit score is. But how many of us know exactly how this mysterious score is actually calculated? A lot of weight is placed on a credit score, so this had us curious. We did a little digging, and here's what we've found.

What is a credit score

A credit score is a three-digit number generated by a mathematical formula using your financial information. According to Bankrate, a credit score is designed to predict risk, specifically, the likelihood that you will become seriously delinquent on your credit obligations in the 24 months after scoring. (Fun fact: There are a variety of credit-scoring models in existence, but most financial institutions use the FICO method. The FICO method is used by Equifax, Experian and TransUnion.)

So how's the credit score calculated?

Your credit score is calculated using information and data from your credit report. Your credit report includes a lot of information, but is essentially a file on you, your accounts and your payment history. This includes a record of where you work and live, how you pay your bills and whether you've been sued, arrested or have filed for bankruptcy.

Data from your credit report is divided into five major categories. The credit score scoring method weighs some of the five categories more heavily than other categories.

Payment History - 35%

This includes how timely you pay your bills - if they're late or on time- and any delinquencies and public records. Payment history is a big one, paying your bills on time can do more to raise your credit score than anything else.

Amounts Owed - 30%

This includes the amount you owe on all your loans, including your mortgage, car or student loans and credit cards. The percentage of available credit you're using on revolving accounts, like a credit card, is heavily weighed. For example, if you're only using $300 of your available $3,000 credit card limit, that will reflect more positively than if you maintained a consistent $2,800 balance on that same credit card.

Length of Credit History - 15%

This refers to how long ago you opened the accounts and the time since account activity. The longer you have an account opened, the more you'll go up in this category.

Types of Credit Used - 10%

This includes the mix of credit accounts that you have. In order to get a perfect score, you'll need a variety of types of credit, such as home, auto, student loans or credit cards. Remember, this is the lowest-scoring criteria, so if you don't have a home, auto, student loan, etc., it's not worth rushing out and getting one just for your credit score. As a general rule of thumb, you should only establish credit, especially a loan, if you need it.

New Credit - 10%

This category can be confusion. Essentially "New Credit" includes how often you pursue new credit, including credit inquiries and number of recently opened accounts. In calculating this piece, FICO looks at, among other things, loan applications and new debts that were added to a credit report in the last six to 12 months. If you have a lot of new credit established recently, you're generally viewed as being "riskier."


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