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Credit scores are some of the most misused and misunderstood numbers that evaluate financial health. There’s a common perception that a high credit score means that a person is wealthy, while a low credit score indicates an individual is struggling financially. Another group of thought believes that credit scores are totally unnecessary and useless. Neither of which is true.
Right or wrong, an individual’s credit score can be used to determine eligibility or trustworthiness in a whole host of situations. In addition to being used for loan applications, credit scores can be used for anything from renting a house to applying for certain jobs. However, in order to really determine its usefulness, we must first understand how a credit score is calculated.
Credit Score Basics
Your credit score is essentially a measure of how well you manage debt. Also known as a FICO score, credit scores range from 300-850. The higher your score, the “better” risk you represent to a lender. FICO scores are calculated based on your credit history. They are reported by three separate credit agencies – Experian, Equifax, and TransUnion. Although each agency has access to the same information, your reported credit score may vary from one agency to the other. Lenders may choose to use a combination of any or all of these scores to determine whether or not they will extend credit to you.
One of the key sticking points, and one of my issues with the credit score, is that you have to actually use debt in order to have a higher score. However, since your credit score is used today to determine your eligibility for such a wide variety of things, most people are going to want to treat their credit score with respect.
5 Factors That Determine Your Credit Score
There are 5 major factors that influence how your credit score is calculated.
- Payment History (35%) – Your payment history is the most important part of your credit score, accounting for about 35% of the total. Basically, this is a measurement of how likely you are to pay back any money that is lent to you based on your past actions. Your payment history includes things like late payments, how often you are late, whether or not you are delinquent on any payments, etc. It also includes any defaults, foreclosures, bankruptcies, law suits, or liens – all of which can have a huge detriment to your credit score.
- Credit Utilization (30%) – The second largest factor influencing your credit score is your credit utilization. This is essentially a ratio of the amount credit you are using compared to the amount of credit available to you. The lower your credit utilization percentage, the better your total credit score will be. So, if you have $10,000 in available credit and are using $2,000, your credit utilization is 20%. This number can be affected by opening up more or less credit. For instance, if you open an additional $10,000 credit line giving you a total of $20,000 available but still only use $2,000, your credit utilization improves to 10%.
- Length of Credit History (15%) – The length of your credit history is the third most important factor in calculating your credit score. Lenders want to know that you have a history of paying back any loans that you have taken out. They want to see that you are able to be responsible for with your debt over a period of time. If you have no history of using credit, this is definitely one place where your credit score can be effected.
- Credit Mix (10%) – Although it is not the most important factor, credit agencies do look at your credit mix when determining your credit score. This part of your credit score takes into account the different types of credit that you use. The best way to increase your score in this category is to have accounts using various types of credit – such as mortgages, installment loans, credit cards, and retail accounts. Since this is just a small portion of your credit score, don’t go out and open a bunch of new accounts to expand your credit mix…especially since it can affect your recent credit activity score (see below).
- Recent Credit Activity (10%) – The final factor that influences your credit score is your recent credit activity. This part of your FICO score looks at how you have handled credit in the recent past. If you have opened up a lot of credit recently, it may suggest that you are in financial trouble. It could also suggest that you plan to put a lot of expenses on credit which you may not be able to pay back. If you have applied for a lot of recent credit and don’t have an explanation for it, lenders may view you as a bigger risk.
Now that you know how your credit score is calculated, you should understand the basics to keeping your credit in good shape. Although using credit can be a dangerous game, it can also be used in a responsible way. As always, use your credit wisely and be sure that you can afford to pay it back!