credit scores

WTF: How Credit Scores Work

Surveys show that many consumers don’t know how credit scores work. Read our guide to understand how your credit score is calculated, and how to raise it.

credit scores

What The Finance is your “dummies guide” to understanding the basics of everyday financial topics. In our W.T.F. series we’ll help you explore every level of business and finance, from what a security is, to how companies hedge their risk–without forcing you to wade through pools of financial jargon.

One such survey, by the Consumer Federation of America (CFA) and VantageScore Solutions, revealed that more than a quarter of the survey takers didn’t know the key ways to raise or maintain their scores.

Similarly, a survey found that almost 50% of consumers thought lenders control credit scores – when in reality it’s measured by credit rating agencies.

Here’s how credit scores work:

A credit score is an abstract number telling lenders how likely you are to pay them back.

Each individual actually has a range of different credit scores, maintained by Equifax, Experian and TransUnion, the three national credit agencies.

However, most of these are not available to consumers, and are used to calculate the one score you’re most likely to see: The FICO score.

More than 90% of all lending decisions in the US are made with this score, according to FICO.

This score ranges from 300 to 850, with 850 being the most creditworthy. The exact method of calculating this credit score is a proprietary formula kept secret by FICO. However, it has revealed the approximate importance of the different factors:

 

How FICO credit scores are calculated.
Chart courtesy of FICO.

Payment history – 35%:

Rather obviously, whether or not you’ve paid other loans on time is the most important part of one’s credit score.

This portion includes payments on credit cards, installment loans, and mortgage loans. Credit scores are negatively affected by certain events that are considered “quite serious” by FICO, including:

  • Bankruptcies (which stay on record for 7-10 years)
  • Foreclosures
  • Lawsuits
  • Wage attachments
  • Liens
  • Judgements

It also includes any late payments, weighing how late they were, how much was owed, how recently they occurred, and how many there were.

Amounts owed – 30%:

As the FICO website states, having debt does not necessarily reduce your credit score. However, if a high percentage of your available credit has been used, it will likely be reduced.

There are several ways outstanding debt affects credit ratings:

  • The total amount owed on all accounts
  • The types of account you owe money on, such as credit cards or installment loans
  • The number of accounts that have balances
  • How much of the total credit line is used (being close to maxing out credit cards is bad)
  • How much of the loan you have paid back, in the case of installment loans

Length of credit history – 15%:

The longer you’ve had your credit accounts, the higher your FICO score is likely to be.

The score takes into account the age of your oldest account, the age of your newest account, and the average age of all accounts. It also tracks the age of each individual account and how long it’s been since you used certain accounts.

Types of credits in use – 10%:

Basically, having an unsustainable credit mix (such as using credit cards to pay mortgages) will lower your score. It’s not necessarily bad to have many different accounts – in fact, people who responsibly manage credit cards will have higher scores than those who don’t have credit cards.

But at the same time, closing an account doesn’t make it disappear from FICO reports, so it’s

important to be mindful when opening a new credit account, especially when considering the last portion of the score:

New credit – 10%:

While FICO recognizes that it’s more common than ever to have and use more credit, opening several new credit accounts over a short amount of time will still lower your score. It also considers any outside inquiries made about your credit scores.

How can I improve my credit scores?

The most important thing is to recognize than paying bills on time isn’t the only component to having a good credit score, as the chart above shows.

For instance, you can have a perfect payment history and a low debt-to-credit ratio on a long-term account, and still lose 20% of your score by suddenly opening up three different kinds of credit accounts.

With the knowledge of how credit scores are calculated in mind, there are five basic tips:

  • Pay your bills on time
  • Keep a low credit-to-debt ratio
  • Stay with the same credit accounts in the long term
  • Don’t use too many types of credits
  • Avoid opening too many new credit accounts in a short period of time.

Updated. Credit scores cover photo courtesy of Mike Linksvayer via Flickr.

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Ole Skaar