The Dreaded Credit Score
What are they and how are they calculated?
One of the most misunderstood aspects of life is how a credit (FICO) score is calculated, what one can do to increase it, and how to maintain a good score.
In general, in order to buy a home, one should aim to have a credit score of between 620 and 760. For some, a 620 score seems like it’s unobtainable because of the slight movements that they see on a month to month basis. For others who have no debt, getting to this score is equally hard because in order to have credit, one must have debt.
So what makes up a credit score? The graphic below is a summary of the inputs to the algorithm that fuels the infamous FICO score.
Let’s dive in to see what each of these categories mean.
Payment history (35%)
The first thing any lender wants to know is whether you've paid past credit accounts on time. This helps a lender figure out the amount of risk it will take on when extending credit. This is the most important factor in a FICO Score.
Amounts owed (30%)
Having credit accounts and owing money on them does not necessarily mean you are a high-risk borrower with a low FICO Score. However, if you are using a lot of your available credit, this may indicate that you are overextended—and banks can interpret this to mean that you are at a higher risk of defaulting.
Within this category, the FICO algorithm weighs credit utilization percentage and the amount owed on installment loans vs. the original balance.
You can calculate your credit utilization percentage by totaling your credit card balances and your credit card limits, then divide your total balance by the total credit limit. Generally speaking, having a credit utilization over 30% will lower your credit score. ex. You have two credit cards, each has a balance of $600 and the total limit of both cards is $4000. To find your credit utilization percentage, you would solve the following formula: ($600 + $600)/$4000 = .3 or 30% credit utilization.
If you have new loans on your credit, you will notice that your score takes a dip also. ex. You just took out a loan to buy a car for $35,000 3 months ago and your remaining principal balance is $34,200. This would lower your score a bit until the loan has been paid down by a larger percentage.
Length of credit history (15%)
In general, having a longer credit history is positive for your FICO Scores, but is not required for a good credit score.
Your FICO Scores take into account:
How long your credit accounts have been established, including the age of your oldest account, the age of your newest account and an average age of all your accounts
How long specific credit accounts have been established
How long it has been since you used certain accounts
Credit mix (10%)
FICO Scores will consider your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. Don't worry, it's not necessary to have one of each, but having two of the five types of accounts will definitely help.
New credit (10%)
Research shows that opening several credit accounts in a short amount of time represents a greater risk—especially for people who don't have a long credit history.
How can you use this information to boost your score?
There is no magic pill to boost one’s credit score instantly. Increasing one’s score is a process that requires time and patience. Here are the methods that work best:
Make your payments on time.
Set up autopay or calendar reminders.
Don't open too many accounts at once.
Request a credit report and dispute any credit report errors.
Pay attention to your credit utilization rate.
If your utilization rate is high, request that your credit card companies increase your credit limit. (potentially HUGE)
When you payoff a credit card, leave it open. Closing credit accounts will affect the length of credit history above and also your credit utilization rate.
If you follow these steps, you will conquer the dreaded credit score, changing it from your most dreaded enemy to your most valued asset.