Credit scores can affect your life in many important ways. First, anytime you apply for a mortgage, car loan, credit card, or financing of any kind, your credit score will typically be looked at to determine whether you are approved or denied for your financing application. If you are approved, your credit scores are looked at again to determine the type of interest rate and terms you will be offered. Credit scores are often the #1 factor considered whenever you apply for a loan.
Since credit scores are generally the first key to loan approval, it is important to understand where your credit scores come from and how they are calculated. There are 3 major credit bureaus in the United States: Equifax, TransUnion, and Experian. If a lender were to pull your credit report and score from each of the 3 bureaus, all 3 of those scores would likely be at least a little different.
There is more than one type of credit score available as well. In fact, there are hundreds. Currently, the type of credit score brand which is most commonly used by lenders is the FICO Score (though VantageScore continues to gain ground in the marketplace).
FICO Scores range from 300 – 850 with higher credit scores indicating less credit risk. The following chart shows the basic makeup of how your FICO credit scores are calculated:
Payment History, which considers factors pertaining to how you have managed your credit obligations both currently and in the past, accounts for 35% of your FICO Scores. This category can also be described as “the presence or absence of derogatory information.”
If you have a history of making late payments on your financial obligations, your credit score will almost certainly be on the lower end of the spectrum. It may sound crazy, but some late payments could potentially damage your credit scores more than any other factor on a credit report including bankruptcy, foreclosure, or repossession (especially if the late payment is severe, recent, and if the account is currently past due).
Amounts Owed accounts for 30% of your FICO Scores. The primary factor considered within this category is your revolving utilization ratio. FICO’s scoring models will consider the amount of credit card debt (aka balances) on your credit report and will compare it to your available credit limits. This higher your debt to limit ratio climbs on your reports, the worse the impact will be upon your scores.
Here is an example of how revolving utilization is calculated. If you have a credit card with a $500 limit and your credit report shows a $500 balance on the account, your utilization ratio is 100%. At 100% utilization your credit scores are practically guaranteed to be impacted negatively. However, keep that same credit card account paid off and your credit scores will almost certainly receive a boost. High credit card balances can significantly lower your credit scores, even if you pay every single monthly payment on time.
Length of Credit History makes up 15% of your FICO Scores. FICO considers the average age of your credit lines as well as the age of your oldest account to determine how many points will be awarded to your credit score for this category.
The older the accounts appearing on your credit reports, the better. Merely opening a new account can potentially lower your credit scores, even if you have never missed a payment on the account – so proceed with caution when applying for new credit. You do not have to be afraid to open new credit; however, you should probably develop the habit of only opening new credit when really necessary.
New Credit makes up 10% of your FICO Scores. One of the primary factors considered within this category is how often you apply for new accounts. Every time your credit report is pulled as part of an application for financing a record of the pull, known as a “hard inquiry,” is added to your credit report(s).
Hard inquiries have the potential to impact your credit scores negatively. However, a “soft inquiry” of your credit report (such as requesting a copy of your own personal credit report) does not hurt your credit score at all. If you have not reviewed your credit reports in a while, you are entitled to a free copy of all 3 of your reports every 12 months from www.annualcreditreport.com. Checking your reports at least several times a year for errors is highly recommended.
Types of Credit Used accounts for the final 10% of your FICO Scores. To maximize your scores in this category it is important to have the right mixture of account types on your credit reports. FICO rewards consumers who show that they have experience managing a variety of account types (i.e. mortgage accounts, revolving accounts, installment accounts, student loans, etc.). The more diverse the accounts on your credit reports the better your scores will fare.