Credit Score. Even the phrase leaves people somewhat guarded, embarrassed, or confused. In basic terms, a credit score is a three-digit number between 300 and 850 generated by a mathematical formula or algorithm. This calculation takes into account your previous payment history and amount of credit outstanding, among other important details we’ll cover shortly.
Your credit score is used by financial institutions and lenders to estimate the risk associated with extending credit. The higher the credit score, the lower the perceived risk to the financial institutions. Currently, the FICO (Fair Isaac Corporation) score is the most popular with approximately 90 percent of all financial institutions in the U.S. using a borrower’s FICO score in their decision-making process. However, other credit scores, like VantageScore, exist and may be used by some lenders here and there.
Regardless of the type of score used, it is beneficial to understand what makes up that all-powerful credit score calculation.
5 Main FICO Credit Score Determination Factors
Payment History – 35%
This portion of your credit score calculation includes your previous payment information, past and current delinquency on payments, and public records relating to missed payments. The credit scoring algorithm leans heavily on these details of your financial past because payment habits are often a clear indicator that you are either responsible with repaying what you owe – or you are not.
Here are some tips for keeping a healthy payment history:
- Paying bills on time weighs heavily in the calculation
- If you missed a payment, get current and stay current – old scores don’t haunt you forever.
- Avoid going to collections. Even if you pay off a collection account, it will stay on your record for seven years.
- If you can’t make a payment on time, don’t wait to contact creditors. Being proactive increases your chances of getting some payment assistance or a reprieve from payments when you need it most.
Credit Utilization (Amounts Owed) – 30%
Your credit utilization – or total amounts owed relative to your credit limits – also plays a role in your credit score calculation. Here are a few things to keep in mind.
- Maintain low balances on credit cards and all revolving credit lines when possible. Creditors like to see no more than 30% used at one time.
- Pay off debt as opposed to moving it around. Consolidating debt to one card may reduce the interest paid in the short term, but may not benefit your score overall.
- Opening more credit cards to increase your credit limit may backfire. Although more available credit may sound like it should help with your score from a utilization perspective, often opening more cards can appear as though you need more access to credit and negatively impact your score.
Length of Credit History – 15%
The length of your credit history is also a factor. Credit score calculations take into account how long ago you opened your accounts, and how long has it been since your last activity on those accounts. Try to abide by the following rules of thumb here:
- Don’t open too many new accounts too quickly as new accounts lower average length of credit history.
- Maintain your oldest revolving credit accounts when possible, even if they aren’t being used consistently.
Types of Credit Used (Credit Mix) – 10%
The mix of credit types across all accounts is also considered. Credit types may include installment loans, revolving credit lines or credit cards, mortgages, or other debts. Remember:
- Apply for new types only when needed. Opening more just for the sake of variety probably won’t improve your score.
- Maintain credit cards, but use them wisely. Someone with no credit history is riskier than someone with a track record of various accounts.
- Closing an account doesn’t make it go away. It still will appear on your record and perhaps influence your score for some time.
New Credit – 10%
The pursuit of new credit requires a check of your credit history and score, which results in what’s called a credit inquiry. These credit inquiries can impact your credit score calculation, so keep these things in mind:
- Don’t take out too many cards too quickly. Rapid credit accumulation can appear risky to lenders.
- Limit inquiries into your credit score when possible, as each inquiry is reported and impacts your score.
Keeping Your Credit Score Healthy
Below are a few tried and true tips for maintaining a healthy credit score.
1. Obtain your current credit report at least once per year
Every American can check their credit report free of charge every twelve months at annualcreditreport.com. When reviewing the report, check for errors. Make sure there are no incorrectly stated late payments or other discrepancies. If you do find errors, immediately call to dispute them with the appropriate credit bureau and reporting agencies.
2. Set payment reminders
Most financial institutions offer payment reminders in the form of email, text message, or even a phone call. Set these up on all accounts possible. Since on-time payments constitute the majority of your credit score, this will ensure you keep track and keep your score healthy. Consider setting up automatic payments before or on the due date to avoid late payments as well.
3. Reduce total debt
Refrain from using credit cards for everyday purchases unless you can, without a doubt, pay off the balance each month. Grocery shopping, gas, clothing are things often thrown on the credit card, however, they can build up quickly. If you don’t think you can pay off these purchases with ease each month, consider using a debit card instead. Additionally, surplus funds not used for other bills or savings should be put towards paying down current outstanding debt, starting with the card with the highest interest rate.
Whether you’re looking to apply for a credit card, auto loan, or mortgage, it’s important to understand your current consumer credit score and the factors contributing to it.