5 Ways Credit Scores Are Calculated
I have heard many people ask how to interpret and understand their credit scores. While credit scores may seem complex, they are actually pretty easy to understand. Having a strong working knowledge of what makes a credit score can have huge benefits for your personal financial planning; high credit scores can help you to qualify for the best loans with the lowest interest rates. There are five components of a credit score: payment history; utilization rate; types of credit used; age of credit accounts; and credit inquiries.
1. Payment History
Payment history is the most basic and well understood aspect of credit scores and it accounts for 35% of the total score. Essentially, payment history measures how frequently you have missed or been late on a payment. Typically your credit score will come from bills such as credit card bills, car payments and mortgage payments; smaller bills such as utilities are usually not reported to the credit bureaus unless you are well past your due date.
The rule of thumb is pretty logical: never miss a payment. Missed or late payments raise an immediate red flag to the credit bureaus because it indicates that you may not be a dependable borrower. If you tend to miss a lot of payments, there is a good chance that you are in financial distress and should not quality for additional lines of credit.
2. Utilization Rate
Credit utilization is often misunderstood, but it makes up 30% of the total score. Basically, your utilization rate is the amount of credit that you have used divided by the total amount that you have available. So, if you have two credit cards, one with a balance of $500 and a limit of $1,000 and another with a limit of $2,000 and a balance of $700 your utilization rate is $1,200/$3,000 or 40%. You should pay attention to the utilization rate for each individual credit account, but the total rate across all accounts provides the most information.
In general, it's best to maintain a utilization rate of below 30%, and it's even better to stay below 10%. This means if you have a credit card with a $1,000 limit, you should never let the balance get above $300. Once your utilization rate start to climb upwards of 30%, it indicates that you probably have more debt than you can easily afford to pay off and you become highly leveraged. One of the best ways to keep your utilization rate down is by paying your credit cards in full each month!
3. Types of Credit Used
This score category is somewhat more vague and makes up 10% of your score. The two primary types of credit are revolving accounts, such as credit cards, and installment accounts, such as a mortgage payment. In another post, I'll explain in more detail some of the differences between the two.
Basically, lenders like to see that you can handle different types of credit. It's good to have a mix of installment and revolving accounts. Essentially this shows that you can balance something like a stable mortgage payment with smaller expenses that you may put on a credit card. There is no perfect answer as to how to do this correctly, but it's good to have a variety of types of credit.
4. Age of Credit Accounts
This is unfortunately biased against younger consumers, but the age of your accounts represents 15% of the total score. Having a long history for each credit account provides a more stable view into past financial decisions and reduces the risk of lending you money. The age of each individual account is taken into consideration, as is the total average age of all credit accounts. The longer your credit history in terms of age, the better, because it provides lending institutions with more information.
5. Credit Inquiries
This final category represents the remaining 10% of your credit score. Basically a credit inquiry occurs anytime you apply for a new type of credit. There are two types of pulls, hard and soft. Hard pulls have an impact and they tend to be things such as applying for a new loan, whereas soft pulls have no impact on your score. A soft pull could come in the form of an employer background check or a pre-approval letter for a credit card in the mail.
Applying for lots of new credit in a short period of time is an indication that you might be a risky consumer suffering from financial trouble. Your best bet is to try to only open one or two new credit accounts per year to avoid too many hard pulls on your score.