For such an important number in our lives, it’s surprising how shrouded in mystery our credit scores remain. Not only do we have to question how to access it, but we also have to wonder how it’s calculated. Over the last few years more information on this has been released, however, giving the general public a peek into how their individual score is determined. These revelations have given consumers the opportunity to improve their scores by understanding how they’re calculated.
The reason for all the mystery is simple: credit scores are calculated by private companies. The best known company is the Fair Isaac Corporation, creators of the FICO credit score. They provide analytics and software to banks, lenders and other businesses in order to calculate credit scores. Not surprisingly, FICO doesn’t want to disclose their exact scoring formula because it’s part of their business strategy. Other private companies have their own scoring systems as well; even the three main American credit bureaus (Transunion, Experian and Equifax) all have their own scoring systems. The FICO score, however, is what most people associate with their credit score.
What FICO has disclosed is what factors affect your credit score, and how strongly each factor affects it. There are five categories they consider in their calculations:
Payment history – this category is the most important to your credit score; it accounts for 35% of the calculation. FICO looks at the payment history of all your accounts in the last several years. It considers the number of late payments and also how late each payment has been. Delinquent payments fall into different categories of severity such as 60 days late or 90 days late. Fortunately for consumers, many lenders don’t report to the credit bureaus if you’re just a few days late. Usually they wait to report until you’re 30 days late. FICO also considers when your last late payment was, and they look at how many accounts have no late payments. All things considered, the most important thing you can do to help your credit score is simply pay your bills on time. If you’ve had issues in the past with late payments, the best thing you can do is bring your accounts current and put your bad payment history farther and farther into the past.
Amount of debt – in this category, FICO considers how much debt you have overall. This accounts for another 30% of your score, so this category combined with the previous one accounts for two-thirds of your score. They look at how many accounts you owe on, and how much debt you carry as compared to your available credit. For instance, an account with a limit of $500 and a balance of $400 will look less positive than an account with a limit of $5000 and a similar balance of $400. Essentially, it’s better for your credit score not to max out your accounts.
Length of your credit history – FICO takes into account how long ago you established your first account. The longer your credit history, the more favorable this will be to your credit score. This category affects your credit score less (only 15%); unfortunately this can be one of the harder factors to improve if you have no credit history. The longer you wait, the harder it is to open a credit account. While it’s certainly good to stay out of debt, many people find it hard to get car loans or mortgages because they’ve never established any credit. For someone having trouble establishing credit, many companies offer secured credit cards. A secured card is financed by the account user; your credit limit is set by a deposit on the account (for instance, $500). The lender holds your deposit and you use the account just like a regular credit card. If you close the account later with a zero balance, you then get your full deposit back. Lenders are willing to set up these accounts because they’re risk free for them; if you fail to pay your account, they can use your deposit to pay off the account. Another thing to consider in this category is keeping your older accounts open. If you want to streamline your accounts and close a few you don’t use, it’s still a good idea to keep one of your oldest accounts open because this will reflect the positive length of your credit history.
New credit accounts – this category reflects new accounts you have and how many recent credit inquires have been made. It accounts for 10% of your score. FICO looks at several new open accounts at once as a sign of a potential increase in debt. This shouldn’t discourage you from opening new accounts; you simply need to be careful not to open several at once. In regards to credit inquiries, this category also considers if lenders have been checking your credit during a credit application. It’s important to remember that not all inquires affect your credit score. When a lender sends you a credit card solicitation in the mail, they’re doing so because they’ve discovered your good credit history after making an inquiry. Fortunately, this does not affect your credit score, because you didn’t request the inquiry. On the other hand if you apply for a credit card or loan, the lender’s inquiry will reflect on your score.
Types of credit accounts – like the previous category, this accounts for 10% of your score. FICO is looking for diversity in your accounts, such as loans and credit cards. They want to see that you have experience paying on an installment account (such as a car loan) and a revolving account (such as a credit card). They’re also looking at your overall number of accounts. This may not be a category you want to proactively improve; it’s not a good idea to open an installment loan simply to diversify your credit accounts. However, if the only account currently on your credit is a car loan or mortgage, you might want to consider opening one credit card. Using one card for a few regular purchases and then paying off the full balance each month will show responsible usage of a revolving account.
Overall, what can you do to improve your credit score?
Pay your accounts on time. This is the best thing you can do for your score.
Don’t carry revolving debt (like credit card debt) from month to month.
Don’t max out your credit card every month.
Keep at least one older account open.
Don’t have more than a few accounts. If you start to have more than five or so accounts, consider closing an account you no longer use.
Don’t open several accounts at once.
Diversify your credit accounts.
And lastly, having no credit history looks almost as negative as having bad credit history. You don’t need to go into debt to establish a good credit score. If you don’t trust having the availability of a high credit limit, open a card with a small credit line. Using it for one purchase a month and then paying it off right away is all you need to establish a credit score. It’s a small thing to do, but it will help you tremendously later on when you apply for a bigger loan such as a mortgage.
Sources:
myFICO.com, “What are the different categories of late payments and how does your FICO score consider late payments?”, http://www.myfico.com/crediteducation/questions/late-credit-payments.aspx
SCOREinfo.org, “The 5 FICO Score Ingredients”, http://www.scoreinfo.org/FICO-Scores/Score-Ingredients.aspx
Wikipedia, “Credit Score”, http://en.wikipedia.org/wiki/Credit_score