How Credit Scores Work

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Credit scores can be confusing, but taking a few minutes to understand what it is and how it is calculated can keep your mind at ease.

proper use of credit cards play a big part in your credit score
“Credit Cards” by Sean MacEntee is licensed under CC-by-2.0 Proper use of credit cards can play a big part in your credit score.

What goes into a credit score exactly? How do credit scores work? For many people, credit scores are a mystery – something used by banks and financial institutions to deny them good rates for loans, credit cards or savings accounts. In reality, your credit score is a calculated number which you can directly impact. Understanding how credit scores work will help you to take control over your credit and use it more responsibly. Learn what factors into your credit score, how long derogatory marks last on your report and the easiest ways to improve your score quickly.

What Factors Into Your Credit Score

The first step to understanding the breakdown of your credit score is understanding that there are multiple credit scores. The most popular credit scoring system is the FICO score, created by its namesake, Fair, Isaac, and Company. This is the score we will discuss here, and the one you are most likely interested in. FICO has made several iterations of their scoring sytem over the years in an effort to make scores more fair and accurate. When you pull your credit score, you should consider two main factors:

Who calculated your score? There are three credit reporting agencies who all have separate records of your credit activity: Equifax, Experian, and Transunion. Lenders and financial institutions may report to different agencies. That missed payment you made? It may only be showing on one of three separate reports on your credit history. Your accounts may appear on all three reports, but don’t be surprised if one score is higher than the others. When applying for credit and your score is pulled, the reporting agency used will impact your score.

When was it calculated? If the information used to calculate your score is stale, it does not reflect your latest credit as it stands now. Certain items may drop off or become added to your report based on the timing of your score calculation. Learn more below about when bad (or good!) marks drop off your report.

How Credit Scores Are Calculated

The exact calculations that result in your FICO credit score are secret, but the relative importance of each scoring criteria are made public by FICO. Accordingly, you can better understand your credit score by looking at each factor. Giving yourself a self-assessment of each area will help you to understand your relative strengths and weaknesses. With that knowledge in hand, try to improve the weakest areas that have high importance. Your credit score breakdown (highest to lowest importance):

Payment History (35%): You should be careful to make on-time payments to all your accounts. Late payments are considered a derogatory mark – missed or untimely payments heavily impact your credit score negatively. You likely are familiar with the importance of making on-time payments – avoid these missteps at all costs.

Amounts Owed (30%): More specifically, the relative size of unpaid loan balances and the percentage of your credit limit you are using on your credit cards. Beware of high percentages of credit utilization for revolving credit like credit cards. High usage of your total credit line across all cards or using a large amount of available credit on a single card are both important to keep watch over. The amounts owed listed in your report depend on the reporting interval for your creditors, but usually reflect statement balances, giving you some level of control over timing. Installment credit like loans are considered separately – making regular payments will show that you are a reliable user of credit as your loan balances make a downward trend. Lastly, a small balance can be better than no balance, since it shows more history of reliable use of your accounts – don’t be afraid to use your credit cards if you can be responsible with them.

Length of Credit History (15%): This factors in the age of your oldest account, how recently accounts are used versus inactive, how recently you have opened new account types and the average age of your accounts. Younger people should not be overly concerned of penalization. Establishing an early credit history will help 18 to 24 year olds (and others with little to no credit!) show responsible use of credit while boosting their average account age. When considering closing an older account, remember the impact it will have on your average account age. Many people recommend keeping older accounts open if there is no fee to keep the account open. Remember to make small purchases on credit cards you use infrequently to keep them active.

New Credit (10%): Avoid opening too many lines of credit in quick succession &nash; as may happen when transferring balances between many newly opened accounts. It is considered a larger indicator of risk for lenders when accounts are opened haphazardly. New accounts also bring down the average age of your accounts as well.

Types of Credit Used (10%): The composition of your total credit portfolio is another factor to your score. Performing well across multiple account types gives positive signals that you are a trustworthy borrower. Your usage of credit cards, loans, mortgages, store credit and other account types shows diverse usage of credit if not misused. If you’re on a rocky road with bad credit, avoid spreading yourself too thin.

Keep in mind that these percentages are averages. Certain groups of people may have certain categories weigh more heavily, but the numbers above will serve you well as a guide.

How Long Does Bad Credit History Last On Your Report

Just how long do derogatory marks last on your credit report? Unfortunately if you’ve made mistakes in the past and are trying to turn your credit around, bad marks on your credit stay for 7 years. Credit scores would not be reliable to lenders wanting to get their money back if a history of missed payments could be wiped from your credit report in a short period of time. It is this penalty that should discourage you from missing any further payments once you have done so. If your report is spotless, be proud of your perfect credit! Having a good credit history is not impossible. Turning around bad credit or improving a good score is firmly in your hands. With bad credit history lasting 7 years, how can you quickly improve your credit? Read on!

Easiest Ways to Increase/Improve Your Credit Score Quickly

Repairing bad credit can only happen as quickly as your behavior changes, but you can get a boost to your score through several techniques. If your worst areas make up a low percentage of your total score (see the breakdown above), you are in great shape. Bad credit factors across the board will not slow you down – they leave a large opportunity for improvement. Here’s tips that will help people with good credit and bad credit alike:

Spread Your Balance: without opening new accounts or increasing your spending, distribute your account balances more evenly between your credit cards and other lines of credit. For those with damaged credit, part of recovery is avoiding the vicious cycle of maximizing your limit and opening new cards to temporarily keep your bills at bay. Your credit utilization is calculated based on the latest numbers from each account – you can quickly change your score by a small amount by paying off balances. A previous month with a high balance will not work against you once that balance is updated!

Ask for a Credit Line Increase: having more available borrowing power allows you to decrease your credit utilization, improving your score with your spending amount left unchanged. Be responsible enough to remember a higher account limit should not translate to more spending. Keep your spending in line with what you can afford to repay, and recall that increased spending will negate any credit score increase from a higher credit line. Many lenders will give increases as frequently as every six months – you may find your limit increased highest if you do not request a specific amount – the credit card company may surprise you!

Get In The Right Mindset: Take the scoring factors into consideration. Once you make your credit score a priority (or at least something you think about), you’ll find your behavior change to optimize each category. Seek help if you need it, but don’t fall prey to anyone trying to sell you access to a higher score, or trying to convince you to open unnecessary accounts. If you work hard, don’t miss payments, overextend your credit or open too many accounts, you stand a great chance at maintaining good credit. Your credit score isn’t something to be afraid of anymore.

3 thoughts on “How Credit Scores Work”

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