Most people go about their daily lives in constant fear of how their actions might affect their credit score. But surprisingly, most people don't even know how their credit score is calculated. To ease some of the paranoia, as well as get a better handle on how lenders are keeping tabs on you, we've broken down the calculation for you here.
There are three major credit reporting agencies that lenders will order your report from: Experian, Equifax and TransUnion. Each of these agencies use a similar formula when calculating your score with five major factors:
Payment History Amount owed Length of Credit History Types of Credit New Credit
Payment History
This consists of about 35% of the equation, making it by far the most important part of your credit history. When bureaus look at your payment history they will take a look at a couple key factors.
First, they will take into consideration how many accoutnts you have in good standing. This means that you don't have any outstanding debts, no late fees and no missed payments.
Next, they will check to see if you have any negative public records or collections pending. This can be a judgment or a lien or it can be a utility company trying to get you to pay a missed bill. Also, if you are disputing a bill and it takes longer than the due date, it may show up here as well, so be careful.
If you do have any delinquent accounts in your payment history, the credit bureau will then take into consideration how many past due items you have, how long they have been past due and how long it has been since you had a past due statement. This means that even if you are a little bit late on a payment, all is not lost. By acting quickly to remedy the rough spots on your credit report, you can control the damage.
Amount Owed
This consists of about 30% of your score. Bureaus take a look at the total amount you owe on all of your accounts, the type of accounts, and how many zero balance accounts you have. This is important because of the balance-to-credit line ratio that credit card companies use to see how liable you for defaulting. That means, if you have five cards, each with a $5,000 credit line, you have a $25,000 total credit line. If you have $2,500 in debt spread over all of those credit cards, then you have about a 10% ratio, which isnt' bad. However, ratios as low as 30% are enough to throw up yellow flags on your credit report, so its best to carry as little balance as possible.
Length of Credit History
Consisting of about 15% of your score, this factors in how long you've had a credit history, how long you've had accounts open, and the time since your last activity. Basically, this tells credit reporting agencies whether you are new to credit or whether you have proven yourself reliable over a long period of time. Naturally, the longer you have had a credit history and the more often you use your credit without issue, the better. Therefore, it is best to start building your credit early, even if it is an infrequently used secured credit card or department store credit card.
Types of Credit
This is about 10% of your score, and factors in the types of credit you use. There are a couple different types of credit that you can take out. The most common-revolving credit-is the type that a credit card is. However, having just one type of credit can actually be detrimental to your credit score. It is better if you can prove that you can handle all types of credit. For instance, a lease, an installment plan, an auto loan, a student loan, a mortgage, etc are all types of credits that require a responsibility.
New Credit
This is the last 10% of your score and is a record of how many accounts you've recently opened vs. total accounts, number of recent credit inquiries, and whether you have re-established your credit recently. Opening many new accounts at once will look fishy in general, so try to stick to a few long term accounts for a better score.
Other factors
When you are closing on a house or applying for a large loan, lenders won't just plug in the number into a formula to determine whether you are trustworthy or not. Often, you'll have the chance to sit down with a lender and discuss any issues on your credit report or give them examples and details on previous loans you've had. So, its always good to be able to explain yourself and account for any issues in your credit history as well as keeping a good credit score.
What is a credit score? A credit score is a three digit number that is formulated using information from your credit report. If you pay your bills on time, honor your debts and handle your finances responsibly, you will have a higher credit score. If you have fallen behind on your bills and neglect to pay your creditors, your score will be quite low.
The most common credit scoring system in use today is the FICO (Fair Isaacs Corporation) system which was created to standardize the scoring process. With this standardized system in place, lenders can take one look at your score and make a decision about you. They do not even have to meet you. They do not have to know how much money you make, and they definitely do not have to know what personal circumstances caused you to fall behind on your bills.
Credit scores range from 300 to 850. If your score is above 720, you will have no problems borrowing money and securing low interest rates. Even if your credit score is substantially below 720, you might still be able to secure financing at a price. You see, lenders calculate their risk using your credit score and offset that risk with high interest rates.
For example: If your credit score is 760 to 799, statistics show that there is a 597 to 1 chance that you will fall behind on your bills. If your score is 500 to 600, there is an 8 to 1 chance that you will fall behind. This means that if a lender loans money to 8 people with credit scores ranging between 500 and 600, one of those people will not pay. So, what does the lender do? Charge the other 7 people higher interest rates to recoup the money lost on the defaulted loan.
This system is backwards to say the least. Well, at least for the consumer. Lenders may be keeping their heads above water, but what about families who are struggling to make ends meet? It is common sense that people who struggle financially will not be able to afford higher interest rates. Take a look: a $200,000 home with a 30 year fixed mortgage at 8% costs the homeowner $96,000 MORE in interest payments than if they had secured the same loan at 6% interest.
As you can see, it is in your best interest to improve your credit score. Even a slight change in your score can impact your finances dramatically. Even if you feel that you have good credit, you should still concentrate on getting your score up. Todays economy has made it very difficult for even the most credit worthy to secure financing. The message from financial advisers is clear: If your credit score is not above 750, you could be in trouble as lenders continuously tighten requirements.
Both Paul Basco & Jay Delgado are contributors for EditorialToday. The above articles have been edited for relevancy and timeliness. All write-ups, reviews, tips and guides published by EditorialToday.com and its partners or affiliates are for informational purposes only. They should not be used for any legal or any other type of advice. We do not endorse any author, contributor, writer or article posted by our team.
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