How are Credit Scores Calculated?
Do you know your credit score? You should, because that three-digit number can have a significant impact on your financial future. It will be a point of emphasis for lenders that are trying to get a sense of how well you manage your finances. Your credit score can tell them how timely your credit payments have been and how often you’ve applied for a new line of credit.
So what exactly is a credit score? Understanding the factors that influence your credit score will help you know how to improve your score and make you more appealing to lenders.
What is a credit score?
Credit scores are a tool used by financial institutions to determine how much risk they would assume by approving a borrower for a line of credit. The higher your score, the more confident a lender might feel that you will be able to repay your debts.
Your credit score will be a number between 300 and 850. If your score is less than 600, it is considered a poor credit score. The range between 661 and 780 is considered a good credit score, with a score of 781 or higher considered excellent.
How are credit scores calculated?
Credit bureaus are responsible for calculating your credit score. Because there are multiple credit bureaus, you have multiple credit scores. Each score is calculated using the same five categories, but each bureau’s specific algorithm used to calculate that score is kept private. As a result, they will likely vary depending on the credit bureau.
But rather than focus on the math, turn your attention to the five basic financial categories that impact your credit score so that you know what factors matter most.
When a lender is reviewing a credit application, the key question they are trying to answer is whether you will be able to repay what you will owe them. This is why your payment history accounts for 35 percent of your credit score. Lenders want to see that you have a history of making your payments on time, whether you are paying off a credit card or making a student loan payment. Late or missed payments have a negative impact on your score.
What is the limit on your credit card? Lenders will want to know how much credit you have available and how much of that credit you are using. The lower the percentage, the better. If you are maxing out your credit cards each month, that could be interpreted by a lender as a warning sign. Credit utilization accounts for 30 percent of your credit score, so make sure that you are demonstrating responsible use of the credit that has been extended to you.
Length of Credit History
Start building your credit as early as possible, because lenders place a premium on borrowers with long credit histories. Your credit score will factor in the age of your oldest account, the age of your newest account and the average age of all your accounts. The result accounts for 15 percent of your score. The longer your accounts have been open and in good standing, the better.
Types of Credit
Credit bureaus subscribe to the belief that variety is the spice of life. The different types of credit you have are also a factor, from credit cards to mortgages and auto loans. This variety will account for 10 percent of your credit score. Just don’t apply for more types of credit than you need, because credit scores will also consider how well you managed having different types of credit.
If you have frequently applied for new lines of credit in a short period of time, that can negatively impact your credit score. Opening multiple new accounts can signal financial troubles, especially if done recently. This accounts for the final 10 percent of your score.
Improving your credit score
Now that you understand the factors that impact your credit score, you know what actions to take and what behaviors to practice to boost that score. You can even periodically request a free credit report to get a sense of your standing and how your credit score is progressing. Credit reports can help identify the specific areas where you need to improve.
If you’d like to further discuss how to improve your credit score, feel free to contact us.