Know how scoring works so you can build better credit.
Let’s face it: credit scores can be really confusing. You see advertisements on TV all the time indicating you have three scores and they all make a difference in whether that auto loan or mortgage lender is going to give you the best deal.
In truth, you actually have more than three scores, because every credit bureau, every lender and every creditor can actually have their own formula used to calculate your risk as a borrower – which is what your score measures.
So how do you know what to pay attention to if you are trying to assess or improve your credit?
Fact: Almost all credit score calculations are based on the formula used to calculate your FICO credit score.
What is a FICO Credit Score?
FICO is the short way of saying Fair Isaac and Company. They are the originators of the idea of a credit score so lenders and creditors can assess the risk of lending you money or extending a new line of credit.
Basically, your credit score tells a lender how likely you are to pay back what you owe responsibly. A high score means you are very likely to pay back everything on time, while a low score indicates you are a high-risk debtor who may default.
Back in 1956 when Fair Isaac started calculating credit scores, they were the only one doing it. However, now you have the three main credit bureaus in the U.S.: Equifax, Experian, and TransUnion. There are also other credit reporting agencies throughout the world and creditors themselves now have their own formulas to calculate risk for their specific type of lending. Each of these credit scores can be different in order to address that company or lender’s specific needs, but they are almost all based on FICO.
So why focus on FICO?
Since all other scores are usually based at least somewhat on FICO, that means understanding your FICO credit score means you understand how to improve your credit, in general. Steps you take to improve your FICO will also improve your credit scores with the three main bureaus, as well as other scores you may have out in the world. It creates one path forward in improving your credit.
How is a FICO credit score calculated?
Our credit score calculation is based on five (5) factors. Each factor has a certain “weight” assigned to it – some factors have a significant impact on your credit while others are not quite as important.
Payment History (35%)
As the largest factor used in determining your FICO score, payment history can make a big difference in your credit rating. With this in mind, building a positive payment history by paying all your bills on time is actually one of the easiest ways to improve your credit.
Debt Owed (30%)
This factor takes into account your total debt owed relative to the amount of credit you have available – in other words, your credit utilization ratio. Since it is another main factor in calculating your credit scores that’s entirely in your control, eliminating credit card debt can go a long way in improving your credit score.
Length of Credit History (15%)
An established borrower is less of a risk than one who is just starting out, so the FICO credit score system takes how long you’ve been a debtor into account. This also factors in the length of time each of your accounts has been open, which is why it’s a good idea to leave old accounts open with zero balances, even if you are not using them.
New Credit (15%)
If you have a number of new accounts opened in the recent past, you are a higher risk as a debtor because you have so many new obligations. With this in mind, creditors want to know how many new accounts you’ve opened recently. They also factor in the number of credit inquiries made in the recent past, since this indicates a debtor seeking several new accounts at one time. Keep in mind, only “hard inquiries” count in your score calculation; “soft inquiries” like checking your credit report yourself do not count.
Types of Credit Used (10%)
The types of credit you use also come into play when determining your credit risk. Some types of debt are more attractive for you to have than other types of debt to lenders and creditors as they assess your risk. A mortgage and a car loan are good types of debt; credit cards are considered better than store cards or retail accounts. This factor also takes into account how often you use different lines of credit you have open.
According to experts, what’s the ideal credit utilization ratio you should have to maximize your credit score?
b) 10%-15%. Although you might think creditors want to see your debts paid in full, in fact, it’s better if you’re utilizing at least some credit to show you’re an active credit user.
How to maintain a strong FICO credit score
Your FICO credit score ranges from 300 to 850 points. Fair Isaac uses the median credit score as a measure of what a good credit score is – according to Fair Isaac and Company a good FICO credit score is 723.
To maintain a good FICO credit score, you can use the following tips:
- Never carry a credit card balance that is over 50% of the available credit line. If your credit card limit is $10,000 on particular line of credit, never owe more than $5,000 on that card.
- Try to maintain a total balance of 10%-15% of your total available credit.
- Always make your payments on time, every time.
- Do not constantly apply for new credit, since too many credit inquiries can hurt your score even if you don’t open the accounts.
- Leave old credit lines open even if you don’t use them.
- Use credit regularly to keep building a positive credit history.
- Check your credit report at least once each year to ensure it is error-free.
- If you find errors, repair your credit.
If you’re taking steps to improve your credit score, then you need to know that the steps you’re taking are actually working. This is where credit monitoring comes into play. You can pay for a service to monitor your credit for at least a limited time until you have your score where you want it to be.