The Anatomy of a Credit Score
Let’s dissect a piece of financial lingo that gets thrown around often, but remains a mystery to those who possess them: The Credit Score. In this blog we hope to break down the different components of the credit score and educate you on what has the largest and smallest impact on them to make them increase or decrease.
Why does it matter?
Credit scores help banks and other lenders determine the likelihood that you will repay the debt that you are applying for. They see your score as a measure of how risky their investment in you is. A worse score signals to lenders that you could be a higher risk borrower and the lender will require a higher interest rate to make up for that risk. Higher scores will indicate lower risk to the lender and an opportunity for you to get a lower interest rate.
Calculating Your Score
The most common credit scores are calculated by FICO using information from your credit history. This history is collected by three main credit bureaus: Equifax, TransUnion and Experian. FICO factors in your payment history, the amount that you owe, the length of your credit history, your credit mix and your new credit history.
Payment History
Predictably, one of the main factors that lenders want to look at before loaning you money is how well you have repaid other debts in the past. In fact, Payment History makes up the largest portion of FICO’s score calculations at 35%. If there is one thing that you can do to help your credit score, it would be to make all of your payments on time. The easiest way to make sure that happens is to set up automatic payments and reminders on all of your accounts.
Pro Tip:
Building your credit score takes time. Patience is key!
Amount Owed
At 30%, the next largest factor of your FICO score is the amount that you owe. There are a few things that go into this area. The total amount of money that you owe is a factor but is often less important than debt utilization and installment loan history. Debt utilization refers to the ratio of current debt in relation to how much credit you are offered on revolving loans like credit cards. If you’ve used your full credit limit on all of your credit cards, you could be overextended and at risk of missing payments in the future. Your installment loan history looks at the relationship between your starting loan balance and current loan balance on loans like car loans, mortgages and student loans. If you have done a good job making payments and decreasing your balances on your installment loans, your credit score should get a boost.
Length of Credit History
Lenders want to know that you’ve always repaid your debts. Proof that you’ve been able to manage debts for a longer period of time, in theory, should make you less of a risk to lenders. For best results in this area (which FICO weights at 15%), avoid closing your oldest debt account if you can. This is an area that will naturally improve over time unless you are constantly opening and closing accounts.
Credit Mix
FICO scores look at the mix of your types of credit when calculating your score. While this area is relatively low impact (10% weight), using a blend of revolving credit and installment loans could be an important factor in obtaining a top tier credit score.
New Credit
The last 10% of FICO’s calculations is the number of new credit inquiries you’ve had in the last 12 months. This is why you will see a dip in your credit score after a new loan or card application. Lenders see those who are applying for several lines of new credit at once as someone who could be a higher risk of default.
Looking at the whole picture.
Credit scores are just one element of your financial life. Since credit scores are a measure of your risk to lenders, you have to deal with one of the most dangerous areas of personal finance: DEBT! Consider this scenario. Sally has $3,000 in credit card debt, $100,000 in student loans and a $400,000 mortgage. For years she has always made her payments on time but she has little in the way of savings and investments. She has a credit score of 745. Jill has a stable early-career income, $250,000 in savings and investments and has never needed to take out loans or use credit cards. She has no credit history at all.
This extreme example brings up an important point; credit score isn’t everything. Yes, Sally has a better credit score, but Jill is in a much better financial position. At Foresight Financial Planning, we look at your entire financial picture to give you the best education and advice for your unique situation. Schedule a free consultation today!
Source: myFICO Credit Education
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