For years credit scores were the best kept secret from consumers by credit bureaus that calculated them.
Only lenders and other credit providers knew what went into a score and how much it weighed on the score’s compositions.
But thanks to pressure from consumer groups and other government agencies, over time not only the credit score number itself has been made available to consumers, but also how the score is determined.
Knowing what affects their scores and by how much, consumers will have a better means in managing their finances.
Factors and the Weights of a Credit Score
There are commonly five recognized factors that make up a credit score: payment history, total amounts owed, length of credit history, new credit being sought, and types of credit used.
Let’s take a look at each of these factors:
Payment History (35%)
Since a credit score concerns mostly about one’s ability to pay, the bulk of it is understandably determined by one’s payment history.
Late payments, missed payments, collection actions, and the worst of all, bankruptcy, lead to different sizes of deductions to one’s credit score.
The number of the negative events and when they happened also matter.
More unpaid bills that occurred more recently would have a greater diminishing effect on one’s credit score. As you can guess, the further you distance yourself from negative payment events the better your score will be as well.
Advice: Pay your bills on time, every time!
Amounts Owed (30%)
The more one borrows against his or her available credit, the more risky the person becomes paying back all the debt.
But a high, absolute outstanding balance owed on many accounts is not necessarily of a concern when deciding one’s credit score. It is the borrowing at a high percentage of one’s available credit near the limit that increases the likelihood of default.
This is a person’s credit utilization or debt to credit ratio.
However, applying for more available credit to lower the debt ratio may hurt one’s credit score even more, while the real solution is to pay down some debt.
Advice: Aim to keep your debt to available credit ratio to below 35%. The lower this ratio is the better!
Credit Length (15%)
Patterns of payment behavior can be established only over time.
Having no credit incidents, such as missed payments or later payments in a relatively short period of credit history contributes little favorable weight on one’s credit score. It is how financially responsible one has been over extended periods of time that serves a better indicator of one’s future financial behavior.
Advice: Avoid the temptation of jumping from one card to another, closing the previous one out each time. Having a couple of go-to credit cards with a longer history is best.
New Credit (10%)
Actively seeking new credit has a negative impact on one’s credit score, as new credit applications may indicate a need for money.
The more recently one applied for a new credit, the more unfavorable impact it has on the person’s credit score. Even having too many potential credit providers check on your credit score can lower your credit rating, unless you’re seriously seeking for a major borrowing.
However, ordering your own credit report is considered to be benign.
Advice: If you think you will need a loan in the near future (buying a car, home, etc.) or there will be an event that may need your credit score then do not open any new credit as this can hurt your score.
Credit Types (10%)
Different types of credit can represent different qualities with varied requirements on borrowers.
For example, installment loans are often harder to obtain than revolving credit.
Thus a mixed use of credit of various types is often seen as endorsements from many unlike financial companies. Having earned the trust from distinctive credit sources has a positive impact on one’s credit score.
Advice: Having credit from different sources can help your score but don’t go out of your way to get loans if you don’t need them. As this only makes up 10% of your score you would do better to make sure you pay your bills on time and reduce the amounts you owe.
The actual algorithm used by the FICO (the most popular credit score) is their secret, but you can get an idea of the strengths and weaknesses of your score from the categories.
Your credit score is an important number that can save you or cost you, depending on your score. Knowing how your credit score is made will go a long way to make sure you have the best credit score you can get.
For more information, see what the Federal Trade Commission has to say about credit scoring.