If you were considering loaning money to a friend, you would probably make a quick evaluation of how likely he is to pay you back. Potential lenders want to do the same, but since they don’t know you personally, they need a more standardized way to evaluate your repayment risk. That is where your credit score comes into play.
It is a number that summarizes the likelihood that you will repay what you agreed, also known as your credit risk, based on your lending and repayment history. The higher your score, the lower your calculated credit risk.
There are three independent credit bureaus – Equifax, Experian, and Transunion – that collect and compile information provided by lenders, collection agencies, and public records. When a potential lender purchases your credit score, the credit bureau generates a number based on the information in your credit report at that particular point in time.
The most widely recognized credit score in the U.S. is called a “FICO Score” because it is generated by software developed by FICO (Fair Isaac and Company). FICO uses a mathematical equation that evaluates the information in your credit report, and compares it to the repayment patterns of hundreds of thousands of past credit reports. The equation yields a number between 300 and 850. Your score may vary between the three credit bureaus because they may have slightly different information in your credit report.
How is it Calculated?
The five factors evaluated from your credit report, and the percent impact on your score, are as follows:
- Payment History (35%) Payment history has the largest weight on your credit score. In general, negative payment history will remain on your credit report for seven years, while good payment history can remain on your report forever. The impact of negative payment history is determined by how late the payment was, the amount owed, how recently the late or missed payment occurred, and how many late or missed payments you have. Public records and collection items are also included in this factor, including bankruptcies, foreclosures, lawsuits, and wage garnishments. These items can have a serious impact on your credit score, although older items and small dollar amounts will have less impact than recent items or high dollar amounts.
- Outstanding Debt vs. Credit Available (30%) Lenders want to know that you are successfully managing the credit you have been given. If you have maxed out all your credit cards, this may indicate that you are overextended, and you may have trouble making future payments. A good rule of thumb is to keep less than 30% of your combined total credit limit outstanding at one time.
- Length of Credit History (15%) If you have established a long history of making timely payments, it is likely that you will continue that pattern in the future. Your FICO score takes into account the age of your oldest credit account, the age of your most recent account, and the average age of all your accounts. While you can’t change this part of your score overnight, you can avoid hurting it by not opening new accounts, which will lower the average age of all your accounts. You should also avoid closing your oldest credit accounts. Keep in mind that since it is only 15% of your score, it is okay to apply for new accounts when you are trying to establish credit.
- New Credit Inquiries (10%) Too many credit inquires may indicate to a lender that you are taking on too much debt, or are in financial trouble. A credit inquiry is when a lender makes a request for your credit report or score. These inquiries remain on your report for two years, although they only impact your score for 1 year. Inquiries do not include unsolicited credit card offers. Checking your own credit report will also not impact your FICO score as long as you order it from a credit reporting agency, or an organization authorized to provide consumer credit reports.
- Types of Credit You Successfully Managed (10%) Lenders are interested in whether you have experience with various types of credit accounts – credit cards, installment loans, and/or mortgages. This factor also looks at the total number of accounts you have – too many open accounts could negatively affect your score. Negative items in this section will not greatly impact on your score, but they may be more significant if you have less information available in the other areas of your credit report.
Why Does it Matter?
It is important to build, maintain, and protect your credit score because it will significantly impact the credit that is available to you, and at what price. The average FICO score is about 690, but only individuals with a credit score above 760 will have access to the lowest interest rates and the most loan choices. Scores of 620 or lower usually place you in the “subprime” category, and you can expect to be quoted significantly higher interest rates. A FICO score of 580 is generally the minimum that will qualify for a mortgage, but most mortgage lenders will require a FICO score above 620-640. Check out the myFICO loan savings calculator that shows the impact of your credit score on interest rates.
For a 4-year new car loan, the difference between a score of 720 and 580 can be as much as 13.5% or equivalent to an extra $8,000 in interest on a $25,000 loan!!
What Can You Do Now?
Building excellent credit can be a long, slow process, but three things that myFICO recommends you do right now are:
- Check your credit report – Identify errors and verify amounts owed on your credit accounts. If you find errors, dispute these with the credit reporting agency and credit bureau immediately. You can get a free report once a year from each of the credit bureaus at www.annualcreditreport.com
- Set up automatic payments or payment reminders – Payment history is the most important factor in your credit score, so make sure you make all your payments on time.
- Reduce the amount of debt you owe – Make a payment plan to reduce your outstanding debt. Check out PowerPay.org to help you pay off your debt. While payment history can remain on your report for years, reducing your outstanding debt to available credit ratio can have an immediate and significant impact on your credit score.