Monday, January 25, 2010

How Is My Credit Score Calculated

Many people have asked me "How do I raise my credit score?" and in return I say "Don't you mean how is my credit score calculated?". Truly understanding how your credit score is calculated will lead to understanding the steps required to raise your credit score. The general purpose of the FICO score is to establish a score that represents how likely you are to pay back the loan. Your FICO score will range from 300 - 850 points and is comprised of 5 components: Payment History, Credit Utilization, Length of History, Inquires, Different Types of Accounts.

Payment History (35%)

As you can imagine payment history is very important, about 35% of your credit score is payment history. Creditors look for late payments, bankruptcies, and collections. Let's face it if you're not paying your other debts your are less likely to pay new ones. If you have problems on your credit report it isn't game over for you. How long ago the problem occurred and how it was handled is also important. As you can imagine a bankruptcies 5 years ago carries much less weight then one a year ago. Also many lenders, such as mortgage lenders, will want to see that you settled accounts. They sometimes will make you settle a bill that has gone to collections before they give you a loan.

Credit Utilization (30%)

How much of your credit you use will also affect your credit score, about 30% of your score is based on your credit utilization. This is one area that people always fight me on. Here is what I hear time and time again "Why do they give me that much credit then fault me for using it". Well I then say to them "We both know that you give your kid lunch money every day and not every month because they will use it all in the first day or two ". The truth is creditors know based on your income and available credit what you can and can't afforded however they have no problem letting to bury yourself in credit debt. You wouldn't let your kid go hungry but credits would.

If you don't want credit utilization to negatively impact your credit score keep the balances on your revolving credit, such as credit cards, under 1/3 or 33%. Let's face it just because your limit is $10,000 it doesn't mean you have $10,000, charging around $3,000 would be more responsible. Credit card companies have a few tricks that can have you maxed out quick. read more about maxed out credit cards: My Card Wasn't Maxed Out Yesterday.

Length of History (15%)

How long you have had your accounts open and in good standing is also important, it makes up about 15% of your credit score. I always tell people that the length of their credit history is like a amplifier to their payment history. Here is a real world example of an amplifier. Your kid starts school and on the second day of school they come to you and say "Guess what I have an A+ in math". Now what does that tell you? Not a whole lot at least not at the moment, now had they told you that 2 week before the end of the school year that would be different story right? That's why the length of your credit history is important.

Inquires (10%)

Whenever you apply for a loan or credit card and inquire is placed on your credit report, about 10% of your score depends on your inquires. You may be asking yourself what difference does it make if I'm trying to get 3 credit cards at once? You may simply be applying for multiple cards because you think more applications will improves your chances right? Wrong, the way creditors look at it is that you are getting ready to take on more debt that you can handle. If you don't want inquires to impact you negatively only apply for one card or loan at a time allow a month or two to pass before attempting to apply for another. I have seen a credit score drop by as much as 10 points because of inquires.

Different Types of Accounts (10%)

Having different types of accounts display your experience with credit, about 10% of your score is based on your diversification. People always say "Doesn't my length of credit history do that" and the answer is no not completely. Having both credit cards and a mortgage shows creditors that you can handle both types of loans. It goes back to the lunch money for school example.

So How Do You Improve A Credit Score

Be responsible with your credit. Pay your bills without maxing out the cards. Keep doing that without attempting to aggressively take on more debt then you should. Credit cards can really do a number on your credit report so try to avoid overuse. Reed more about the downsides to credit cards: Are Credit Cards Really "The Devil".

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