Welcome back to our series on credit. Last week we talked about what your credit is and I gave you some basic, but important, definitions about credit. This week we will delve a tad bit deeper and discuss how your credit score is calculated.
Your credit score, or FICO score, is a computer generated summary calculated at the time of the request and is based on information a credit bureau or lender has on file for you, and is based on data about your credit history and payment patterns. Your score is calculated by both the positive and negative information on your credit report. The data is grouped into five different categories: amounts owed = 30%, payment history = 35%, new credit=10%, length of credit history=15% and types of credit in use=10%. These percentages are based on the importance of the five categories for the general population.
Late payments will lower your score, but establishing or re-establishing a good track record of making timely payments will raise your score. Let’s breakdown these percentages a little more so you will understand why it is important to stay on top of your credit.
PAYMENT HISTORY 35%: The first thing any lender wants to know is whether you have paid past creditors on time. Now you see why it is the largest percent of your credit. A few late payments are not an automatic score killer. An overall good credit history can outweigh one or two instances of late payments. On the reverse end of this, having no late payments does not mean that you will have a perfect score. Remember, your payment history is just one piece of information used to calculate your credit score. Had I have known this years ago, I would have made more of a concerted effort not to overextend my credit and to pay my bills in a timely manner.
AMOUNTS OWED 30%: Having credit accounts and owing money on them does not necessarily mean you are a high risk borrower with a low score. However, when a high percentage of your available credit has been used, this can indicate that you are overextended, and are more likely to make late or miss payments. This was exactly what happened to me. I was overextended and my payments were late and some weren’t made at all.
LENGTH OF CREDIT HISTORY 15%: In general, a longer credit history will increase your credit score. However, even if you haven’t been using credit that long, you may have a high credit score depending on how the rest of your credit report looks. Your credit score takes into account: how long your credit accounts have been established, including the age of your oldest and newest account and an average age of all your accounts; how long specific credit accounts have been established; and how long it has been since you used certain accounts. Today I can say that my credit history from the low point in my life has not repeated itself, thank God!
NEW ACCOUNTS 10%: Research shows that opening several credit accounts in a short period of time represents a greater risk especially if you don’t have a long credit history. If you have been managing credit for a short period of time, don’t open a lot of accounts too rapidly. Newer accounts will lower your average account age, which will have a larger effect on your credit score if you don’t have a lot of other credit information. Now don’t think that if you have a long credit history that opening a new account can’t affect your score because it can. Even if you have used credit for a long time, opening a new credit account can still lower your score. Opening a new account will likely produce a credit inquiry on your credit report. The new inquiry may have no effect at all, or it may make your scores go down slightly, depending on the type of inquiry and the number of inquiries already present on your report. For example, applying for credit excessively can almost be expected to have a negative impact on your scores, as most inquiries tend to indicate a higher credit risk. So be careful when applying for credit. When I was going through my ordeal I had every credit card known to man. Today I have 2 cards and one store account. I maintain those accounts to keep my score high. I use them sensibly and I don’t shop around for new credit.
TYPES OF CREDIT IN USE 10%: Types of accounts such as credit cards, retail accounts, installment loans, finance accounts and mortgage loans will be considered when tabulating your credit score, however it is not mandatory that you have one of each and it’s not a good idea to open credit accounts that you have no intention of using. The open accounts that I maintain on my credit report are two credit cards, which are considered revolving accounts, and an installment account, which is a small furniture account. These are accounts that I have had over 10 years (excluding the furniture account) and maintain a good payment history. Accounts that are included on my credit report that show paid in full are three automobile loans, a mortgage loan and my student loans. This mix of accounts, their age and my payment history on them made it a cinch to obtain financing on a new property my husband and I just acquired. So as you can see being credit conscious plays a major role in aiding you to live the lifestyle you desire.
Join me next week as we explore ways that you can clean up your credit.