Your credit score: It’s a constantly changing number floating around out there, and it has major impact on your financial life. It’s a big factor in determining how much credit you can expect from lenders, what interest rate you will pay on your loans, and even how much you will pay for car insurance!
WHAT IS A CREDIT SCORE?
The first step in understanding your credit score is figuring out what a credit score really is. When people talk about credit scores, they are generally referring to a FICO score. FICO stands for “Fair Isaac Corporation”, the major credit scoring company. FICO creates a formula to generate a score from 300-850 based on factors in your credit history. The credit reporting bureaus (Equifax, Transunion and Experian) use that formula to calculate your credit score based on the information they’ve collected on your credit history. When a lender wants your credit score, they request it from the credit reporting bureaus. Of course, a higher score is better.
It is important to realize that you don’t have just one universal FICO score. FICO produces many versions of their credit scoring formulas and they have different formulas based on your personal credit profile. So, the formula used to calculate your credit score probably won’t be the same one used to calculate my score. Also, there are industry specific FICO scoring variations, so the credit score used for your auto loan won’t necessarily be the same credit score used for your credit card or mortgage application. Because of this, no matter how much you stay on top of your credit report and how often you check your own credit score, you don’t know exactly what score your lender is going to see when evaluating your credit worthiness.
WHO LOOKS AT YOUR CREDIT SCORE?
Your credit score is seen as a measurement of your financial responsibility, so as you might imagine, it is accessed in many situations. Here are some situations in which your credit score might be pulled. Some of these are obvious, but others might be a surprise.
- Credit card application
- Mortgage application
- Auto loan application
- Applying for a lease – landlords check your credit to see if you are likely to pay your rent on time.
- Current creditors – they check your credit score periodically to see if they should increase your interest rate or offer you more credit.
- Employers – a prospective employer will often run a credit check as part of your background check to determine how responsible you are.
- Insurance companies – they check your credit score when determining your insurance premium. Who knew that a bad credit score would cause you to pay more for your car insurance?
- Utility companies – they check your credit score and will often require you to pay a deposit before starting utility service if your credit score is low.
WHAT DETERMINES YOUR CREDIT SCORE?
Your credit score is calculated based on a number of factors, each of which are assigned a particular level of importance in determining your score. All of these factors add up to show a lender how responsibly you will handle your available credit. We will address ways to improve your credit score in a future article, but right now, we’re just going to summarize what determines your credit score in the first place.
The following are the categories of information used to determine your credit score. The percentage next to each category represents how much it contributes to your FICO credit score.
FACTORS WITH THE HIGHEST IMPACT ON YOUR CREDIT SCORE
PAYMENT HISTORY (35%): The most important factor in determining your credit score is whether or not you pay your bills on time. FICO considers your payment history on the following types of accounts:
- Credit cards
- Retail accounts (like department store credit cards or loans made by a retail store)
- Installment loans (loans where you make regular payments, like a car loan)
When evaluating your payment history, FICO considers how late your payments were, how often you missed your payments, how much you owed, and how recently your missed payments occurred. More recent missed payments have a greater impact on your credit score than older missed payments.
Derogatory marks on your credit history are also considered as part of the payment history category. These include bankruptcies, wage garnishment, collections, and foreclosures.
- Why does this matter? – Clearly, a lender wants to see that you have a history of paying your bills on time. If you have a history of missing payments, you are more likely to continue to miss payments in the future.
AMOUNTS OWED (30%): Another very important factor used in determining your credit score is how much you owe on your debts. This is measured by your credit utilization ratio: a measure of how much debt you have compared to how much credit you have available to you. Most experts recommend keeping credit utilization below 30%.
Credit utilization ratio = amount owed ÷ available credit
In addition to your overall credit utilization, your credit score takes into account the amount you owe on specific types of accounts, like credit cards, mortgages, installment loans, etc. More weight is given to the credit utilization ratio on revolving credit, like credit cards, than for other types of accounts you may have.
- Why does this matter? – If a lender sees that you are using nearly all of your available credit, they know that you don’t have much of a margin for error in your finances. If an unexpected expense comes up, you might not have enough credit available to handle the expense. This could cause you to have trouble paying your bills.
FACTORS WITH A LOWER IMPACT ON YOUR CREDIT SCORE
LENGTH OF CREDIT HISTORY (15%): In general, if you have a longer credit history, your FICO score will be better. This is not determined by your age, but by how long you have been managing credit. Your credit score will be affected by:
- The age of your oldest credit account, your newest account, and the average age of all of your credit accounts.
- How long it has been since you’ve used your accounts.
Because the age of your credit accounts matters, be cautious about closing old credit card accounts even if you don’t really need them anymore. Closing long standing credit accounts can negatively affect this portion of your credit score by decreasing the length of your credit history.
- Why does this matter? – If a lender sees that you have a long history of using credit responsibly, there is a good chance that you will continue to use it responsibly. And like anything else, practice makes perfect; so managing your credit is something you get better at the longer you’ve been doing it.
CREDIT MIX (10%) – While it is not necessary to have every type of credit account open, FICO likes to see that you have some variety in the types of accounts you have used.
- Credit cards
- Retail credit accounts
- Installment loans
If your entire credit history is based on one credit card account, your credit history won’t look as strong as it would if you had a variety of credit account types.
- Why does this matter? – Showing that you’ve used a variety of accounts demonstrates the ability to manage different kinds of debt. Paying your car loan, where you have to make the same payment every month is different than paying your credit card bill, which can vary considerably from month to month. Being able to manage both shows strength in your credit history.
NEW CREDIT (10%) – The new credit portion of your score is determined by the number of new credit accounts you’ve opened, or attempted to open recently. Opening a number of credit accounts over a short period of time will have a negative impact on your score.
When you apply for new credit, the lender checks your credit history. This type of credit check is known as a “hard inquiry” and it can lower your credit score. Hard inquiries only will affect your FICO score for 1 year.
A hard inquiry should not be confused with a “soft inquiry” like checking your own credit report, a credit check that is done as part of a background check, or when a creditor pulls your credit report when offering you a pre-approved credit card.
One important exception to the way that multiple hard inquiries affect your score is in the context of shopping for credit. If you are about to take out a mortgage or a auto loan, you will probably shop around for the best interest rate, and this will require each lender to perform a hard inquiry. When multiple inquiries are performed over a short period of time for the same type of loan, FICO recognizes that you are shopping for a loan and generally counts it as only one hard inquiry. A good rule of thumb is to limit the duration of your credit shopping to about 30 days to ensure that your multiple credit checks are recognized as credit shopping.
- Why does this matter? – Opening multiple new credit accounts over a short period of time can indicate to lenders that you are in financial trouble and that you are trying to meet your financial obligations by accessing more credit. This can be a red flag that you’re getting in over your head with your use of credit.
WHAT DOES NOT COUNT TOWARD YOUR CREDIT SCORE?
According to FICO, the following factors are not considered when determining your credit score.
- Marital status
- Race and national origin
- Occupation and employment history
- Where you live
- Child/family support obligations
- Whether or not you are participating in a credit counseling program
To access your FICO score, visit myfico.com, there is a fee for this service. If you are curious about your credit report and your credit score, you can check out free credit monitoring websites like Credit Karma or Credit Sesame. While the credit scores on these sites are not true FICO scores, they are a good approximation of generally what you can expect your score to be. These services are useful for monitoring your score and identifying ways in which you can improve your credit score.