If you're like most people, you know what your credit score is. But do you know exactly how this mysterious score is actually calculated? A lot of weight is placed on a credit score, and if it's low, it can have a huge negative impact on your life. Naturally, knowing how a credit score is calculated can make all the difference.
What is a FICO credit score
Let's start with what a credit score is—a three-digit number generated by a mathematical formula using your financial information. A credit score, or FICO score, is a number used to assess your credit risk and/or credit worthiness; it is based on a consumer's credit history over the past seven to 10 years. Generally, scores range from 350 to 850. From a creditor's perspective, the higher the score, the less likely someone is to default on their credit obligations.
How is your credit score calculated?
Three major credit bureaus compile credit scores, and each uses a slightly different model and algorithm to calculate scores, so don't be surprised if your number varies. Your credit score is calculated using information and data from your credit report. This 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 if you've filed for bankruptcy, among other things. Data from your credit report is divided into five major categories, listed below. The credit score scoring method weighs some of the five categories more heavily than others:
- 35%: Payment History This includes how timely you make your debt payments (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.
- 30%: Amounts Owed This includes the amount you owe on all your loans, including your mortgage, car, student loans, and credit cards. The percentage of available credit you're using on revolving accounts, like a credit card, is heavily weighted. You don't want to spend more than 30% of your total credit limit, but don't worry too much if you go over this limit for a short time. 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.
- 15%: Length of Credit History 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.
- 10%: Types of Credit Used 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 borrow if you actually need to.
- 10%: New Credit This category can be confusing. Essentially, new credit includes how often you get new loans or revolving credit (this category includes things like credit cards and lines of 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" because you have not yet established a history to show you can afford new payments.
What matters most to your score
Three things pack the biggest punch, so these areas are where you'll want to focus most of your energy:
- Your payment history
- The amount you carry on credit cards
- The length of your credit history
Your score is lowered if you are chronically late with payments, max out your credit cards, or have a shorter credit history. Keep in mind that your score is constantly changing and is recalculated with changes like paying off a credit card, so your score can differ month to month. Just be sure that you make all your payments on time, try not to carry more debt than you have to, and keep your credit card accounts open to help lengthen your credit history.
What is a credit score used for?
Unless you're a millionaire or can pay for everything (including buying a house) in full with cash, your credit score can affect your entire life. This includes finding an apartment to rent, insurance premiums, the interest rate you pay on any loan you might need, and the terms of that loan in addition to any fees.
If you've made a major purchase like a house or a car, you're probably familiar with how your credit score factors into the terms of your loan. Although credit score isn't the only factor, it is a big one. The higher your credit score, the better the terms on your loan. This translates to lower interest rates and sometimes lower fees, which of course means lower payments.
Boost your score
About a third of your credit score is linked to payment history, so keep accounts current. Lower the balances on credit cards that are maxed out. Your score will improve when a credit card balance is less than 50 percent of the credit limit and keeps improving as you continue to pay down the balance. You may not want to close a credit card that you have stopped using because that card helps to establish a longer credit history. But the account shouldn't sit unused, so make regular charges and then make timely payments. Otherwise, your credit card provider may close your account due to inactivity and potential risk of fraud (you wouldn't notice if a card you don't use was lost or stolen, for example).
Check your credit report every year
Not only does this help you stay on top of your debt and keep in mind what you owe to which companies, you can also make sure your identity hasn't been stolen and fraudulent accounts opened in your name. You can get free copies of your credit report from all three major credit bureaus at AnnualCreditReport.com. If you are ever asked to pay to get a copy of your credit report, don't cough up anything! By law, your reports have to made available to you once in a rolling 12-month period. So, if you check your reports in June, you can check them again the following year on or after June.
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