Your credit score, a number ranging from 300 to 850, represents your trustworthiness as a borrower. A higher credit score can help reduce your insurance premiums and improve your ability to qualify for new employment, housing, and loans at favorable interest rates.
As I shared in my previous article, individuals have a number of different credit scores. The most important type is your FICO credit score, which is used in roughly 90% of all lending decisions.
FICO, a private corporation, uses an algorithm to analyze your credit reports and generate a credit score for each report. Although FICO doesn’t release their exact credit scoring model, they do provide a basic breakdown of the individual credit scoring factors that are considered.
The remainder of this article will provide a detailed explanation of the five scoring factors that are used to calculate your FICO credit score.
Your payment history is the most important factor in determining your FICO score.
Lenders are most concerned about your ability to repay outstanding debts. If you have a history of neglecting your payment obligations, future lenders will be unlikely to lend you money.
Your credit report includes a detailed record of your payment history, including several important notations:
Charge-offs and collections
Bankruptcy, tax liens, or court judgments
Delinquencies are late payments, often reported as 30, 60, 90, 120, or 150-days late. Most creditors don’t report missed payments until they become at least 30 days late.
After six months of nonpayment, the lender can do a “charge-off” if they believe that you will never repay the debt. When a charge-off occurs, most lenders will sell your debt to a collections agency, a move that also goes on your credit report. Lenders can also pursue wage garnishment through a court judgment as a means to collect any outstanding debt.
While late payments will negatively affect your credit score, the charge-off process is much worse. Late accounts can be brought current, but charge-offs and collections cannot.
Any negative remarks will remain on your credit report for seven years, except Chapter 7 bankruptcy which remains for ten years. However, the negative effect on your credit score will diminish as time goes on because recent payment history is heavily weighted in the FICO scoring model.
Amounts Owed (30%)
This category is often called credit utilization, which is the ratio of your current credit being used to your total credit available.
For example, if your credit card balance is $2,000 and the overall credit limit is $10,000, your credit utilization is 20%.
The credit utilization for each individual account matters, but your total credit utilization across all accounts is far more important. Furthermore, revolving lines of credit (credit cards) are more heavily weighted in the utilization ratio than installment loans.
FICO and VantageScore both recommend that your credit utilization remain below 20%. Their line of thinking is that a high utilization ratio indicates an overextended credit profile, which suggests a lower probability of repaying the debts.
More specifically, FICO recommends that you use maintain low credit utilization over time. They officially state, “… a low credit utilization ratio will have a more positive impact on your FICO Scores than not using any of your available credit at all.”
That doesn’t mean that you need to pay ridiculous interest charges, only that you make purchases and occasionally show a small balance on your monthly credit card statement.
Again, directly from FICO, “Your credit report will reflect the account balance that your lender reported to the credit bureau (typically the balance from your latest monthly statement). So even if you pay your credit card balances in full each month, your account balance won’t necessarily show on your credit report as $0.”
Credit History (15%)
Your credit history is the overall age of your credit profile. That includes:
Age of oldest account
Age of newest account
Average age of all accounts
Amount of time since accounts have been used
A long credit history suggests stability and predictability in your borrowing behaviors.
New Credit (10%)
FICO believes that “…opening several new credit accounts in a short period of time represents greater risk – especially for people who don’t have a long credit history.”
Opening too many accounts in a short amount of time will have a small negative impact on your FICO score, as will having too many credit inquiries.
When a lender requests your credit report or score, a credit inquiry is shown in your credit report. If credit inquiry was initiated by you (e.g. loan or credit card application), that is known as a “hard credit inquiry,” which affects your credit score. If the credit inquiry was initiated by the lender (e.g. a preapproval), that is considered a “soft inquiry,” which does not affect your credit score.
Hard credit inquiries remain on your credit report for two years, although FICO Scores only consider inquiries from the last 12 months. Soft credit inquiries also remain on your credit report for two years, but never affect your credit score.
Credit Mix (10%)
There are two main types of credit – revolving lines of credit (any type of credit card) and installment credit (most loans).
Lenders prefer to see a mixture of each, but it’s not a hard requirement.
According to FICO, “The credit mix usually won’t be a key factor in determining your FICO Scores—but it will be more important if your credit report does not have a lot of other information on which to base a score.”