This definitely qualifies as a Frequently Asked Question…
How is your credit score calculated?
Your credit score, usually called a FICO score after the company that created it, Fair Isaacs and Company, is a mathematical number that’s anything but fair. Because more recent activity on your credit repair is weighed most heavily, it’s a system where years of good behavior can be erased with one small mistake.
It’s hard to interpret your credit score meaning, because credit score calculations are a trade secret. They don’t have to tell us what goes into calculating them, other than the raw data. This is why we’re entitled to one free annual credit report under the Freedom of Information Act, but we aren’t entitled to a free copy of our score.
What the credit bureau does is compile a lot of information about you and your spending habits, dumps that raw data into a fancy mathematical formula called and algorythym, and splits out a 3-digit grade of your paying habits compared with others in the country.
While we don’t know the exact calculation, we do know some things. Below is a chart copied from MyFico.com, explaining the broad credit score categories.
As you can see, the largest chunk of your credit score, 35% is based on your payment history.
Put simply, it’s whether or not you make your payments on time, every time. It’s your history of late payment, if any, or chargeoffs, collections, bankruptcies and delinquencies.
The easiest way to improve this largest chunk of your credit score is pay your bills on time, and remove any evidence of contrary actions from your credit report. Remove more recent items before working on older ones. More current transactions have a greater impact on your score.
The next largest percentage, 30%, has to do with the amounts you owe. Specifically, the bureau looks for how much you owe compared with how much you COULD owe. In other words, they want to know if your credit cards and “maxed out”.
You improve this part of your score by keeping your credit both well distributed between your available sources of credit, and keeping your ratio between the amount of debt you owe versus the credit available to you at about 30%.
The next 15% of your score is based on the length of your credit history, and the longer and more consitent the better. Most of us can’t change the length of their credit reporting, with the exception of one area. Don’t close old credit cards. When you close an old credit card, it will eventually cease being part of your credit report. As long as the card is open and active, you get the benefit of the years of credit history.
For example, if you’ve had one credit card for 20 years, and you one day decide to close it, that 20 year history will be removed from your account in 7 years or less. If you keep it open, you maintain a long credit history, so at the end of the 7 years your credit is better from a 27 year old account, then potentially shorted to a 7 year old account (depending on your other credit).
The remaining two categories are both 10%, one is for new credit, and the other is the types of credit you use.
Credit bureaus like to see that you are regularly applying for new sources of credit and using credit to your advantage. They also score you higher if you’re using several different types of credit, like revolving credit and installment loans.
Here’s another question from a reader:
I’m afraid to check my credit score because it will lower my score, so how do I find out about my credit?
That’s one of the common myths out about credit, that checking or pulling your own credit report will hurt your credit score. And it doesn’t. It doesn’t affect it at all. You can check your credit every day if you were so obsessive and inclined.
There are two great sources for checking credit. First, you can get a free credit report once a year from each of the three credit agencies by visiting this link Free Credit Report.
Second, if you’ve already gotten your free report, you can get a really great tri-merged report, that pulls all of the credit reports on one report, by visiting this link Tri-Merged Credit Report.
I was talking to someone today who has an 820 credit score and he’s afraid to apply for any loans because he doesn’t want to lower his credit score. Which brings me to this question…
Won’t applying for new credit lower my score?
If you have a high credit score and are afraid to apply for credit, what good is that?
Credit’s out there to be used and to be used to make you money. And that’s what I’m so passionate about. There are hundreds of other people that talk about credit and credit score. Very few people talk about how to use it to get wealthy, and that’s really the purpose of credit.
Having good credit without the borrowing power behind it is merely a bragging right. It’s like having a high SAT score with no intention of getting into college.
When you apply for credit it does create a small “ding” or dip in your credit score. However, when you get approved for the credit that has excess capacity, like a credit card or line of credit, I promise, it will actually increase your score.
I ran into someone in a hotel lobby. She came up to me and said
I’m not one of your customers, but I did hear you on a teleseminar. I took one action that you said to do and my credit score increased by 7 points.
Me: “what did you do?”
Applied for a new credit card.
Like I’ve said many times…everything you know about credit may be wrong…
