How Credit Scores Are Calculated
Many people, both in the finance field and outside it, often refer to credit scores, but not everyone knows what a credit score actually is and what it is made up of. There are lots of articles covering this topic online, but many of them contain an overwhelming amount of information, so I’d like to cover the basics.
Your credit score is a number ranging from 300 to 850 (the closer to 850, the better) that signals how trustworthy, or risky you are to potential creditors. It is comprised of five different factors and offers a "snapshot" of credit worthiness at any point in time.
There are five factors that go into calculating your credit score:
1. Payment history is the biggest single factor, accounting for 35% of your score. Potential creditors obviously want to know if you make your payments on time. A late credit card payment or two will not necessarily destroy your score if the rest of your credit picture is good, but the more consistent you are about paying on time, the better.
2. Outstanding balances constitute 30% of your credit score. Creditors look not only at how much you owe, but also at the ratio of outstanding balances to available credit on your revolving accounts. Maxed out credit cards are a dead giveaway that you are overextended, which will lower your score. Opening several credit accounts at one time to increase your available credit can also lower your score because it creates the impression that you may be in financial trouble and need access to lots of credit.
3. Length of credit history makes up 15% of your score. This factor takes into account how long you have been using credit, how long your accounts have been open, and how long it has been since you last used them. A longer credit history gives a more complete picture of a person’s spending and paying habits. If you have no credit history, your score may be low in this area for a while, but you can still have a good overall credit score if your other factors are strong.
4. Type of credit is 10% of your score and is made up of the total number of accounts you have and how many of each kind. Creditors regard borrowers who have a mix of revolving credit and installment loans as lower risk. Exactly what ratio constitutes a good mix varies for individual borrowers, so avoid opening accounts you don’t need in an attempt to improve this score.
5. Recent Inquiries make up 10% of your score. Having a new credit card or loan is not a problem in itself, but opening several new accounts in a short period of time can be indicative of a cash flow problem and will hurt your score, especially if you are new to credit and your history is brief. Having several recent inquiries from prospective lenders on your credit report can hurt you, too, since it can be a sign that you’ve been turned down for credit and have applied with other lenders.
Credit scores are constantly changing, for better and for worse, depending on your credit activity.
For example, opening up a new credit card account or financing a purchase might lower your credit score in the short term because of the increase in activity; however, over the long term, having a credit card with a $10,000 limit and only utilizing $500 could increase your credit score because it shows that you are not maxing out your credit limits and over using your card.
The best way to maintain a good credit score is to be responsible in using credit and don’t open or close accounts thoughtlessly.
If you’d like more details, here are some great places to get them: