We all know our credit score is important. A good credit score can be the key to buying your first home or purchasing a new car, but exactly what a credit score is, and how it is calculated is much more confusing. In fact, a recent study found that 40% of Americans were unsure of how their credit score was calculated. Even if you have a strong understanding of the components that make up your credit score, it never hurts to review them when planning out purchases or big life events. In this post, we unravel the components that go into your credit score and identify a few key strategies for improving credit.
In short – your FICO credit score is a three digit number that informs a lender of your credit worthiness. Most lenders use your FICO credit score to determine whether or not to provide you with access to credit, and at what cost. While the exact formula used to calculate your Fico score is a proprietary secret, FICO does provide the factors it uses to calculate your score and a rough measure of how much each factor is weighted.
There are six factors that impact your credit score. These factors include:
Payment history
Your payment history includes an overview of all the payments you have made on your credit accounts. According to FICO, credit information history on your payments make up approximately 35% of your credit score. Lenders report how many payments you have made on credit cards or personal loan) history and whether each monthly payment was made on time. The best way to control this part of your credit score is to ensure each monthly payment is consistently paid. Emergencies happen from time to time but even accidentally missing a payment or late payment can negatively impact your credit score. Lenders like to see that you have made a high ratio of your payments on time – think 98% and up to be in the category of “good credit!”
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The 2nd most influential component of your credit score is your credit utilization rate, or the amount of your extended credit you use each month. Credit utilization makes up approximately 30% of your credit score. Think of your credit utilization as the total outstanding credit card balance or debt divided by the total combined credit limit of your cards. If you have one card with an outstanding balance of $1,000 and a limit of $2,000 – your credit utilization ratio would be 50%. Many financial coaches will recommend keeping your credit utilization below 25-30%, but in general the lower the better. To keep your utilization ratio lower, consider making two payments a month on credit cards to cut your utilization in half. Together, credit utilization and your payment history make up nearly 70% of your credit rating so you will see the biggest impact to your score from focusing on these two components.
Credit history length:
Your credit history length is another component considered by FICO, and makes up approximately 15% of your credit score. Some credit scoring tools will show you the average age of your credit accounts, while others will show you the age of your longest account. Creditors like to see that you’ve managed credit well over time so the goal is to have a longer credit history. If you’re young and just getting started on your credit journey – don’t worry, just remember to try to keep your first account open for as long as possible because over time this account will become essential for showing a long history of managing credit.
Credit mix
Credit mix makes up 10% of your credit score. Your credit mix is determined by the types of credit you have access to. Creditors like to see a diversified mix of credit accounts including credit cards and loans. Thought creditors like to see a diversified mix of accounts, you shouldn’t open an account just to diversify your credit mix – a best practice is to only apply for credit or loans you need, but credit mix does make up a small component of your credit score.
Generally, there are two types of accounts that creditors like to see revolving credit, and installment credit. Revolving credit is credit that is automatically renewed each month, like a traditional credit card. Installment credit, includes your auto loan, most mortgages, and personal loans. Installment credit loans typically have a set payment and are paid over a set period of time.
Service accounts such as utility accounts or your rent account are not routinely reported to credit bureaus and generally do not impact your credit score. There are a couple of instances when a relationship with a landlord of utility company can impact your credit. First, most utility companies and rental agencies will check your credit history prior to opening a relationship with you. In the next section we discuss the impact a “hard credit inquiry” can have on your credit score. If you are behind on your rental or utility payments and your account is ultimately charged-off, this will be reported on your credit history as a “derogatory account” and will negatively impact your credit--further risking “bad credit”.
New credit
The final component of the scoring model is new credit. There are two signals lenders use to identify new credit risk: the number of your accounts that are under 2 years old, and the number of recent inquiries on your credit reporting history. Inquiries appear on your credit report when you apply for a loan or credit card and a lender “pulls” your credit score. Credit accounts are considered “new” for two years, and likewise, inquiries stay on your credit report for two years. Applying for too much credit in a short period of time can be a sign of risk the credit reporting agency and will have a negative impact on your credit score in the short-term. There is good news though, if you are shopping for a car or home and want to compare options from several different lenders within a short period of time, these credit inquiries will not be duplicated on your credit report because you are applying for one credit product. To ensure your score isn’t negatively impacted, only apply for the credit you need when you need it, to avoid carrying a high amount of hard inquiries on your credit report.
Summary
Collectively these are the factors that make up your credit score. Given the weighted impact of your payment history and credit utilization (65% of your total score), those factors have the highest impact on your score and if you are trying to improve your credit focusing on making your payments and using a smaller amount of credit each month can go a long way to improving your score. We hope you found this useful, and please let us know what other questions we can tackle in our next post!
