Understanding Your Credit Score
Over 90% of lenders use your credit score to determine the amount of risk involved in making a particular loan. The higher your score, the lower your risk to the lender.
The score, often referred to as your FICO score, was created by the Fair Isaac Corporation in 1989. It’s based on credit files held by the three credit bureaus, Experian, Equifax and TransUnion, and uses secret, complicated principles of higher mathematics to predict risk.
The general formula is comprised of about 30 characteristics that fit into five categories. Each characteristic is weighted differently, depending on when it occurs in your credit life and on the type of FICO score. For example, your mortgage score may be slightly different than your bankcard score, which may be different than your score for an auto loan.
All three credit bureaus use FICO scores in their own risk predicting models, and your score can vary depending on the bureau and the model.
So what are the five categories that comprise your FICO score?
- 35% payment history, or timeliness of payments
- 30% capacity, or amount owed
- 15% length of credit history
- 10% new credit
- 10% type of credit used
It pays to pay! Late payments have an enormous effect on your score. One 30-day late payment can reduce your credit score up to 110 points! The higher your score, the more points that are lost from negative activity.
Length of credit history
Everyone has to start somewhere. A new borrower with one 6- to 12-month line of credit (also known as a “trade line”) should have a credit score in the 640-660 range, depending on the type of credit line and the balance. With each perfectly paid trade line, the credit score will increase. Everyone should have at least one small revolving line to keep their credit score alive; without an active trade line, the score will revert to zero in six months.
Capacity is the amount owed on loans compared to the available credit or original loan amount. One of the easiest ways to improve your score is to keep your capacity ratios in line. The FICO model considers three components when assigning capacity points.
- Installment balances vs. original loan amount. (Installment loans have a beginning, an ending and usually a certain monthly payment amount, like an auto loan.)
- Revolving balances vs. revolving credit limits. (Revolving loans have a set credit limit, but as you pay down the balance, the loan is available to use again. Credit cards are revolving loans.)
- Total revolving balances vs. total revolving limits
Your capacity score will be higher if you have a high amount of available credit, which is done by keeping your revolving balances as low as possible. It takes discipline to maintain good capacity. Pay off all revolving accounts monthly if possible and avoid closing revolving accounts. For scoring purposes, it’s better to have small balances on a number of cards than to have a large balance on a single card.
Sit FICO®—Good Boy!
Lenders are not the only entities interested in your credit score. Landlords, insurance providers and even employers sometimes use the score as part of their background checking procedures. If your score isn’t as high as you’d like it to be, don’t lose heart.
First, check the accuracy of your report by going to www.AnnualCreditReport.com and downloading a free copy. If you find any errors, follow the instructions on the site to report them. Then, start working on raising your score.
Things to avoid
- Payday loans
- Taking too many loans in a short period of time. This is called escalating debt and is a bankruptcy predictor. Lenders will often close or lower available credit lines if they see this happening.
- Co-signing for others. If you put your name on it, it’s YOUR debt.
Things to do to keep your score high
- Make payments on time.
- Mind your capacity.
- Spread out your debt by not opening multiple credit lines in a short period of time.
- If possible, pay off revolving lines each month. This helps you maintain good capacity levels and saves money on interest.
- Be patient. If you are diligent, time will fix old mistakes and scores will improve.
If you’re serious about increasing your score, write down your goals, develop a written budget and stick to it. You’ll find lots of helpful resources right here on Truity’s website. Begin with Balance and My Finance.