An individual’s credit score is often the key to obtaining loans, mortgages, and other sources of funds. It matters not only because it makes it possible to gain credit approval, but also because it is used to determine the borrower’s interest rate, credit limit, and other credit terms. Many are familiar with this number, but they know little about its calculation. What is a credit score and how is it computed?
What Exactly is a Credit Score?:
Credit reports are usually the first place to check when investigating credit and they can be obtained free of charge at least once per year. But much to the surprise of many consumers, a credit report is just that: A report showing your personal financial history. It doesn’t indicate your actual credit score.
The credit score I am referring to is the FICO score. FICO is an acronymn for the company (Fair Isaac Company) that created this widely used credit barometer. FICO takes into account several personal financial factors and from them, it derives a score that ranges from a low of 300 to a high of 850. This score is an important factor (one of many) that creditors use when they decide whether or not to extend credit because it indicates personal reponsibility in regards to debt management.
What Factors Comprise My FICO Score?:
An individual credit score is comprised of calculations from five main areas:
Payment History: This is the most important factor of all and it accounts for 35% of your credit score. It takes into account the timeliness of payments to creditors of all types (credit cards, car loans, mortgages, home equity loans, etc.), delinquencies in payments, bankruptcies, the elapsed time since a payment was past due, the number of past due accounts, the number of accounts paid in a timely manner,etc.
Amounts Owed: This is the second most critical component of a FICO score, accounting for 30% of the final score. This calculation looks at the total debt owed, the money owed to specific creditors, the number of accounts with a balance owed, and the proportion of balance presently owed compared to the original loan amount or credit limit.
Length of Credit History: Credit history accounts for 15% and it considers the elapsed time since an account was opened and the time since there was any activity in the account.
Types of Credit Used: Here, FICO looks at the number of each specific type of credit account in your credit report. This accounts for 10% of your overall credit score.
New Credit: Obtaining and/or seeking out new credit accounts for 10% of a consumer’s credit score. It looks at the number of newly opened accounts, the number of credit report inquiries from potential creditors, the elapsed time since accounts were opened, and the time since inquiries were made.
As you can see from the above categories, there is more that makes up a FICO score than people realize. Making payments on time matters the most, but there are several other factors at play- activities and actions that can increase or lower your credit score without the consumer doing much of anything.
The most common factor that consumers fail to realize is the last one, New Credit. Each time a credit inquiry is made on your personal financial records, your credit report is flagged and your FICO score is adjusted downward. The reason for this is because FICO considers excessive inquiries for credit as a signal that you may be desperate for funds and applying for numerous credit opportunities until you get what you need. This is why it is important to avoid allowing creditors to continuously make inquiries into your account. For example, when shopping for a car, it is best not to give out your Social Security number to multiple dealerships because each time you do, an inquiry will be made and it will slightly lower your FICO score.
Among the components of a FICO score, the ones that matter the most and count for the most are exactly the ones you would expect: Payment history and total balances owed. This is why it is so important to pay bills on time and keep total indebtedness under control. Those who are not sure about their credit history and payment history should obtain a credit report and examine it closely. There could be late payments, long since forgotten, that are working to lower the overall FICO score.
If you have a recent history of delinquency, it will lower your FICO score, but there is still time to get your financial house in order. Make it a point to pay bills on time and, if necessary, initiate automatic bill payments directly from your checking account to make sure the money is received on time. Send in extra payments when you can and avoid any new credit until you have first taken care of existing debts. A few simple financial moves like these can lead to a higher FICO score, easier accessibility of credit, and lower interest rates on future debt.
Copyright 2011, Bryan Carey