Anatomy of a Good Credit Score
Fair Isaac Corporation revolutionized the world of credit and lending when its FICO scoring system entered mainstream use in the 1980s. Fair Isaacs developed their secret FICO formulas by comparing how various credit report indicators – such as late payments, credit utilization, etc. – relate to credit default rates. Your FICO score is a mathematical analysis of your creditworthiness based on the data contained in your credit report. While there are other scoring systems than FICO, the FICO score is by more the most widely used.
When you say you have “good” or “bad” credit, you are referring to the numerical value of their FICO score. Your FICO score tells banks, credit card companies, and other lenders how likely you are to make good on your promises and repay your debts. Although your individual credit score may not reflect your creditworthiness completely, banks can accurately determine credit risk when analyzing large groups of people who all have the same score.
Just like higher grades are given to better students, higher FICO scores are given to borrowers with better credit. Your FICO score in part determines the interest rates you receive on credit cards, loans, and mortgages. Your FICO score can also influence your insurance rates, whether you qualify to rent an apartment, or are hired for a job.
Given the importance of a good credit score, how do you go about improving yours? First you need to understand what goes into calculating your credit score. Fair Isaac does not disclose the exact credit scoring algorithm. However, Fair Isaac does provide the following general information regarding the calculation of credit scores:
- Payment History (35%). About one-third of your credit score is determined by your past payment history. Your payment history includes your account payment information, any adverse public records involving bankruptcy or delinquency, the severity of delinquency in both time and amount, the number of past due accounts, the number of accounts paid as agreed, and the amount of time since anything negative.
- Amounts Owed (30%). Again, about one-third of your credit score is determined by your credit utilization. Fair Isaac looks at your account balances, how much of your available credit you have used, and what types of accounts have balances. Since the type of account is considered, a $100,000 mortgage balance is interpreted much more favorably than a $100,000 credit card balance.
- Length of Credit History (15%). The length of time you have had credit influences your credit score. A longer, more established credit history increases your credit score. A short credit history cannot conclusively demonstrate good credit, and thus can hurt your credit score.
- New Credit (10%). Fair Isaac looks at whether you have recently opened any new credit accounts. A flurry of new credit accounts signals a potential financial or credit problem, which can hurt your score.
- Types of Credit (10%). Your FICO score is in part determined by the mix of credit that you have – credit cards, retail cards, mortgages, installment loans, etc.
Your credit report is the key to improving your credit score. Your actions and decisions directly reflect what goes on your credit report, and consequently, your credit score. Your credit score is solely determined by the information in your credit report. If something’s not found in your credit report, it has nothing to do with calculating your credit score.
Once you understand what makes up your credit score, you can take steps toward improvement. Let’s look at each of the factors and see how you can boost your score:
- Payment History. Pay your bills on time; it’s the single most important thing you can do to improve your credit score. Avoid late payments and bankruptcy.
- Amounts Owed. Keep your account balances low. Don’t run your credit card balance up to the limit. Try to keep your credit card balances less than 30% of your credit limits. Since unused credit boosts your score, think twice about closing unused credit cards if you plan to apply for a loan in the short term. Too much unused credit can harm your score, however. Lenders see excessive amounts of unused credit as rope that you can use to hang yourself financially.
- Length of Credit History. Start building credit early in life and have patience. While there’s nothing you can do to make time pass more quickly, you can learn to have patience. Building a reliable, on-time payment history over time pays great dividends to your credit score. It’s important to begin building credit early in life. If you wait until later in life to open a credit card, you may have insufficient credit history length to qualify for good terms on, say, a mortgage.
- New Credit. Apply for new credit sparingly. Applying for a large number of credit accounts can indicate potential credit trouble. If you plan on applying for a major line of credit, such as a home mortgage, try to avoid signing up for any new credit cards unless absolutely necessary.
- Types of Credit. Try to maintain a healthy mix of credit types. Having too many credit cards may adversely affect your score, although not universally true. Two or three credit cards are all you need to build your credit history. Extra credit cards can be a pain to keep track of, and could lead to accidental late payments.
Your experience with various types of credit can improve your score on specialized versions of the FICO score. For example, banks evaluate your credit report on slightly different criteria when you apply for mortgage. Prior experience with mortgages can help your score when buying a home.
- Error correction. Check your credit report often, once or twice a year at a minimum. Errors can and do happen, which can sometimes hurt your credit score. When you check your credit report, make sure all the information on the report is accurate. Some credit card companies, such as Capital One, can negatively impact your score by refraining from reporting certain account details. For example, Capital One does not report the credit limits of its customers’ credit card accounts. While credit card companies are not obligated to report anything, the missing credit limit information can adversely skew FICO’s analysis of your credit utilization. If maximizing your credit score is important to you, avoid credit cards like the Capital One cards that do not report credit limit information.
Follow these simple tips and you should see your credit score rise gradually over time. Our best advice for you, however, is to not agonize over your credit score. Even if you’ve had credit problems in the past, if you pay your creditors on time from now on and have patience, you’ll be fine.
