Calculating Your Credit Score
In my last blog piece, I discussed the importance of your credit score, what it means and how it can help you. Now that you know what is considered a good score, let’s learn how your credit score is calculated.
How is it calculated?
There are five major categories that are considered when a FICO® score is generated. The importance of each category varies slightly for each individual, but the basic concept is the same, and some of the categories overlap. Let’s take a look at the five categories:
Payment history (35% of your score) – It’s not surprising that this is what most lenders want to know. Do you pay on time? It’s the most important piece of your score.
Amounts owed (30% of your score) – The most important concept to understand is your ratio of balance-to-max-credit. Your score will improve much faster if you have a $2,000 credit card limit, but you only use $200 per month. On the other hand, if you have that same $2,000 credit card, and you keep $1,999.99 borrowed on that card every month, you can easily see how that would lower your score because from a lender’s viewpoint you appear to be unable to manage your spending habits. Likewise, a $10,000 car loan that has paid down to $2,000 over the course of a few years would show the ability to properly manage monthly payments and would help raise your credit score.
Length of Credit History (15% of your score) – There’s no better time to start than right now. If you’ve never had any credit accounts, or if you’ve made some mistakes in the past – now is the time to start rebuilding your credit. Length of time with positive payment history is a key part of your score (and you can see that it overlaps from #1 above). If you’ve ever heard the old saying, “Time heals all wounds” then you’ll understand this part of your score. Even if you make a mistake and miss a payment, start making payments on time and as time goes by, your score will improve.
New Credit (10% of your score) – Whether you’ve never had credit before or if you are opening a new car loan or credit card, opening several new credit accounts at one time adversely affects your score until you can show a history of timely payments (are you noticing the trend yet?). The key is to open accounts slowly and separately to allow each account to generate a positive effect on your score after you’ve opened the account and have been able to show positive payment history (roughly 4-6 months). Inquiries also affect your score – so don’t let everybody and their mother pull your score.
Types of Credit in Use (10% of your score) – It’s no secret that credit cards can be dangerous if not used responsibly. So, it shouldn’t be a surprise to you that if the only type of account on your credit report is credit cards, your score is going to be low. However, if you have one home loan, one or two car loans, and a couple of credit cards, then that would be a sensible mix of credit types.
As I mentioned above, you can see that the categories each have some overlap and the overall theme of how the score is calculated is based on length of positive payment history. Keep everything paid on time and no matter what mix of accounts you have, you’ll end up with a higher score over time.