How The Heck Is My Credit Score Determined?
Posted on 04/26/2018
Everyone wonders how a credit score is calculated. Would it surprise you to know that you actually have many, many scores? That is a scary thought because most people have no idea what goes into a credit score and how their actions influence them. The good news is that what most lenders rely on is what’s known as your FICO score.
The history of the FICO score is an interesting one. Earl Isaac, a mathematician, and William Fair, an engineer, founded it in 1956. They called their company Fair, Isaac and Company, hence the acronym FICO. The two men met while in California where they were working at the Stanford Research Institute. Within two years of formation, FICO approached 50 American lenders and was successful in selling its first credit scoring system. After taking the company public in 1986, FICO went on the New York Stock Exchange. It rolled out the first FICO score, meant for general purpose, in 1989.
FICO scores give lenders the ability to see into your financial picture, and they use certain criteria to score your creditworthiness. Most consumers have a lot of anxiety about their credit score because much of it, along with how it’s calculated, seems mysterious and complicated. While your score is a result of complex formulas, you should know some basic things. Paying attention to these categories and understanding their role in calculating your score can go a long way toward helping you manage your credit picture.
To understand how your credit score is calculated, you’ll need to understand the categories used and how they comprise your total score. Let’s walk through these categories and explore the ways they influence your credit score.
Your payment history is one of the biggest determinants of your credit score. This is because FICO and lenders both feel that past behavior is one of the best indicators of future behavior. This is why FICO assigns 35% of your total score to your payment history. While payment history is your past ability to pay your bills on time, there are also some other factors included in this category.
Your payment history takes into account several different types of accounts including credit cards, auto loans, and mortgage loans. It also looks for any derogatory information on public record against you, such as bankruptcies, liens, judgments, and/or collection actions. If you’re behind on your payments, it’ll look to determine how long your accounts have been overdue and what the overdue amounts are.
FICO will also score any delinquencies less harshly the longer it’s been since the delinquency, collection, or public record event occurred. If you do have past due accounts, it’ll consider how many you have as well as how many are being paid on time based on the original agreement with the lender.
In order to arrive at your FICO score, information from your credit report is analyzed and various algorithms applied. That’s why what’s on your report is so very important, inherently more important than your score. While it sounds simple, there are actually factors that make the process quite complex. As an example, not all creditors report late payments in the same timeframe. This can cause your credit score to wax and wane over the short term. Your credit report is a much better reflection of your payment history than your credit score is. Bottom line: if you’ve been responsible and made your payments on time in the past, you’re well on your way to a good credit score.
FICO weights 30% of your credit score on credit utilization, but it’s a mystery to most consumers. The term “credit utilization” is somewhat counter-intuitive to what it really means. Your credit utilization percentage derives from the amount of credit you’re using compared to the amount of credit you have. For example, if you have one credit card with a $10,000 credit limit and you carry a $3,000 balance, your credit utilization is 30%. Creditors like to see a low utilization percentage, as this is an indication that you’re not dependant upon your credit cards to meet everyday expenses. As a rule of thumb, keep your credit utilization under the 30% mark.
With regard to credit utilization, be careful in trying to game the system by opening more credit card accounts to change your utilization percentage. Having lots of open credit can also work against you, as lenders know there’s the potential for you to get in over your head. Since the precise way credit scores are calculated is still somewhat of a mystery, doing something that you may think will help could actually end up hurting your score.
Closing old, paid off accounts is not always a good idea either. This gives you less available credit, which could raise your utilization percentage. However, if closing accounts is the right thing to do for you to help manage your finances and keep you from running up balances, go ahead and do it. It’ll only benefit your credit report in the future. In addition, there’s no point in paying annual fees on cards you don’t need or are no longer using.
Always be mindful of the timing of opening new accounts. If you’re in the midst of applying for a mortgage, you don’t want to raise any red flags with the lender processing your loan. In reality, you shouldn’t do anything that could affect your credit during your mortgage processing. Even paying down balances with excess cash might be a bad idea, as many lenders like to see a healthy savings account.
An important thing to remember is that credit card companies will usually report your outstanding balance to the credit bureaus at the end of the billing statement, when they produce your statement. If you pay your balance off entirely before the billing period ends, you’ll affect your credit utilization positively. The credit bureaus won’t give you extra credit for paying it off early because they usually only care about whether you made the required payment on time. However, it’s always a good idea to pay off your balances in full every month if you can. Contrary to popular belief, you don’t need to carry a balance on your credit card to build your credit. Besides, carrying a balance just means that you’re paying interest every month.
Length of your credit history
The length of time you’ve had credit will account for about 15% of your FICO score. Many believe that you must have credit for a long time in order to have a good report, but that’s not necessarily true. Having good credit over a long period is obviously a good thing, but you can establish a good credit history in a relatively short period. It’s more about managing the credit you have well, though it’s necessary to have credit for some length of time for a credit score to be calculated.
It’s better to have credit that’s a little less than perfect than it is to have no credit at all. Without any kind of a credit history, banks will be reluctant to lend money to you and, if they do, they’ll likely charge you a higher rate. This is because they have no idea what type of borrower you’ll be, thus lending you money poses a greater risk.
Generally, FICO considers three things when looking at your length of credit history. First, it wants to know how long your current accounts have been open. More specifically, there are certain accounts it’ll be more interested in than others. Lastly, it’ll want to know how long it’s been since you used your accounts. It’ll consider your youngest and oldest accounts and calculate an average of all of your accounts combined. In order to have a credit score, you need to have had at least one account open for six months or more.
Even accounts that you’ve closed will continue to show on your credit report for 10 years. Therefore, a closed account paid as agreed will boost your length of credit history. Accounts with late payment history, however, will continue to show up on credit history for seven years from when you were first late with your payments.
Those who are averse to carrying debt and tend to pay cash for everything can sometimes find themselves in a situation where they have no credit score at all. If it’s been several years since you’ve used a credit card, and you don’t owe money on things such as a mortgage or a car, it’s quite possible you’ve disappeared off FICO’s radar. Then, when you go to make a purchase that you want to finance, you’ll find highly reluctant lenders. This may be true even if you’ve paid off a home or car and been very responsible with your money.
Some consumers, especially young people, find themselves in a quandary when trying to establish credit when they have no credit to begin with. One of the easiest things to gain approval for is a retail credit card or a gas card. This is because the lending standards are usually lower because credit limits on the cards are generally small. Therefore, starting with a gas card that has a $300 limit can get you off to establishing some kind of credit history. In addition, if you have a good banking relationship with the bank where you have a checking or savings account, you might ask for a credit card with a small limit.
If you have no luck with obtaining any kind of credit card, you can always ask your bank for a secured card. A secured card requires that you place a deposit with the bank as a form of security against the card. These are generally easy to qualify for since there’s very little risk to the lender. You can use the card to make small purchases and then pay it off every month. After about six months, you’ll begin to establish a credit history. If you do a good job with a secured card, many lenders will let you upgrade to an unsecured card with a small credit limit after a period of time, usually a year.
Credit mix and new credit
Credit mix and new credit are two different things, but they both weigh equally on your credit score, coming in at 10% each.
FICO will look at the mix of types of accounts you have in order to evaluate this portion of your credit score. Generally, the thinking is that borrowers who have a variety of accounts are better at managing their debt. So, having a mix of credit cards and various types of loans will likely bump your score up a bit, assuming you’re making all required minimum payments.
For new credit, FICO is interested to know how many accounts you’ve opened in the past year. This means that opening too many accounts in a short period could have an adverse effect on your credit score, especially if you have a relatively short credit history. This is because it’ll affect your overall account age, which has a larger influence on your credit score overall. This is true even if you have a relatively long credit history.
In addition to new credit, FICO will look at how many times potential creditors have accessed your credit data lately, usually within the last year.
Managing your credit score can be an intimidating task. However, it’s important to couple efforts to improve your credit score with a strong foundation of good money management skills. If you’re responsible with your money and utilize credit in wise and responsible ways, a good credit score will always follow.