Credit scores are one of the most confusing aspects of personal finance. You don't have just one credit score, you have multiple scores. To make matters more confusing, different lenders use different scores and there are no standards for how your credit scores are calculated. Here are several tips to help you make sense of how credit scores are calculated and what you can do to improve your finances.
Many Different Credit Scores, Similar Scoring Factors
Your credit score is simply a number that lenders use to predict whether or not you'll pay them back. The "score" comes from complex formulas used by different companies to calculate how much of a risk you are for a loan.
Most credit scoring formulas rely on data from your credit reports. The first step to ensuring your credit score is as high as possible is to make sure the information in your credit reports is accurate. You don't have to pay for credit reports. The law requires reporting agencies to give you access to your reports once per year. You can access these reports for free at the website AnnualCreditReport.com.
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The law has several protections built in when it comes to your calculating your score. Credit scoring algorithms are prohibited from using your ethnicity, religion, gender, national origin, or marital status when calculating your score.
Factors Affecting Your Credit Scores
Different scoring models all share common factors in their calculations. Your history of making payments on time is one of the most important factors for maintaining acceptable credit. The way you use credit, including the number of open accounts you maintain, is also a factor. Another factor is the amount of time that you've been using credit and your most recent activity. Finally, if you've had accounts enter collections, foreclosure, or bankruptcy, those will have a large impact on your score, too.
One of the most commonly used scores is the FICO score. FICO comes from the Fair Issac Corporation and the company discloses the makeup of their scoring model.
According to Fair Issac, your payment history accounts for 35 percent of your score. This includes the number of accounts reporting on-time payments and the number reporting late payments. The amount your payment was overdue is also a factor.
Next, the amount you owe on your credit reports account for 30 percent of your FICO score. This takes into account your debt-to-income ratio, which is simply the total amount you owe compared to your income.
The length of your credit history accounts for 15 percent, the amount of new credit you have contributes 10 percent, and finally the types of credit you use factors in the remaining 10 percent, according to the Fair Issac model.
While every score is different, the Fair Issac scoring model gives a glance behind the curtain of how your credit score is calculated. Maintaining a high credit score is important for more than getting a mortgage or a car loan. Your credit score could affect employment decisions, too, which is why responsible use of credit and paying all of your bills on time is so important.