How is a Credit Score Derived?
Now you see that there are three different credit bureaus that report your credit history independent from each other and that they each assign you a credit score that can range from as low as 300 to as high as 850. So how do they do it? In the US, credit bureaus typically use a credit score model called the FICO system. FICO uses mathematical algorithms and statistical models to create your credit score. Although the exact formulas are not made public, the following components have been disclosed.
Payment History (35%): Your payment history is the most important category and has the greatest impact on your overall credit score. Each month, as you pay your bills on time, it improves your credit score. On the other hand, late payments it can have a dramatic negative effect on your credit score. The more recent you are late, the lower your credit score and a history of late payments on several accounts will cause more damage than late payments on a single account.
A quick list of major derogatory (negative) items that can significantly lower your credit score are:
- Late payments over 90 days past due
- Any information in the public records section of the credit report. This includes bankruptcies, tax liens, judgments, etc.
- Collection accounts
- Charge-Offs
- Repossessions
- Foreclosure
- Short Sale
Amounts Owed (30%): It surprises me how many people are not aware of the large role that “amounts owed” plays in the make up of their credit report. For example, I had a borrower that I helped refinance last month who was shocked when he found out his credit score was much lower than he had thought it was. He didn’t have any late payments so he thought his credit report was perfect. I reviewed his credit report with him and saw that he had an $8,000 balance on his credit card with a $10,000 limit reporting. This may not sound like a big deal, but after doing some maneuvering and getting the balance down his credit score increased 57 points in less than three weeks. Instead of obtaining a mortgage at 5.75%, he was able to get an interest rate at 4.875%.
The two standard types of accounts that dominate a credit report are installment loans and revolving debt accounts. Installment loans, such as car loans or mortgages, have set payments and terms, and the lower the amount that you owe relative to the initial loan amount the better. Revolving debt accounts, like credit cards and lines of credit, have a greater impact on your credit score. I have seen that once your balance exceeds 50% of your limit on a credit card, it starts to drop your credit score. The higher you are to being “maxed out” or “over the limit”, the greater the drop. If you are able to maintain the balance of your revolving debt accounts below 30% of their limits, your credit score will typically increase month over month. Here is an interesting fact, if you want to increase your credit score, it is better to leave a small balance (again, under 30% of the limit) on your revolving account rather than pay it off. This may seem counterintuitive to many financially prudent people, but credit companies like to see a history of maintaining debt and good payment history. Therefore, an account with a small balance with a history of on-time payments will increase your credit score where as an account with zero balance will typically neither increase nor decrease your score. Of course, this creates a level of risk that you may miss a payment. Finally, having too much available revolving credit can also have an adverse impact on your credit score.
Length of Credit History (15%): The longer your credit history, the better it is for your score. Also taken into consideration is how long it has been since you used certain accounts and the average account age of your existing open accounts.
New Credit (10%): The two things to consider here are the number of new accounts and new available credit and the number of recent inquiries that that appears on your credit report. Statistics prove that opening too many new accounts in a short period of time increases the risk of default as it could lead to “spending sprees” or “debt pyramiding”. If you need to open new accounts to establish (or reestablish) credit, a wise decision would be to open no more than one account every six months and no more than three accounts in a 24 month period.
Having too many inquiries in a short amount of time will have a negative effect on your credit score. One thing to consider is that you can shop for the best deal. Having multiple inquiries for the same purpose – such as shopping for a car – in a short amount of time (typically 30 days) is generally looked upon as one “hard inquiry”.
Types of Credit (10%): Credit scoring models look for a healthy balance of installment debt, revolving debt, store charge accounts, etc. Some experts believe that the ideal mix for the best credit score is a few credit cards with relatively high limits and only a small balance on one or two of them along with an installment loan with a spotless six-month payment history.
More to read
