Credit scores have become increasingly important in the last few decades. A mysterious number that somehow represents an individual’s trustworthiness is now virtually the sole factor behind whether or not a loan for a car, house, or big screen TV will be issued, and at what interest rate. Once realized, this fact suddenly leads consumers to consider a three-digit number to be of extreme importance, and questions arise.
How are these numbers calculated? Which factors make the biggest negative impact on a score? Should a credit card be canceled once it is paid off? Should credit of all kinds be avoided at all costs?
Answers to these questions can be difficult to find, and there may not be a clear answer to all of them. The exact formulas used to calculate credit scores are closely guarded, and every bureau and organization that deals with credit uses its own equation, though a company called FICO is generally considered to use the most standard and correct calculation method. However, knowing what makes up a credit score and how much a credit mistake affects that score goes a long way to helping everyone better control the future of their credit purchases.
Before reading further, it is important to be familiar with two basic credit terms and their meanings.
- Credit Bureau – a company (not a government entity, but a for-profit business) that collects credit information about consumers and calculates credit scores. The three best-known and most often used bureaus, commonly referred to as “the big three,” are Equifax, Experian, and Trans Union. Credit bureaus make a large portion of their profit from creditors that pay for credit information on potential customers that need loans.
- Creditor – a company or entity that loans money to consumers. Creditors are usually banks, but they can also be retail stores, automobile manufacturers, or anyone that loans money. Creditors provide information about those they loan money to to the credit bureaus so that records can be kept and scores calculated. Not all creditors, however, report to credit bureaus.
The factor that tends to make the biggest difference in a credit score is payment history. This is basically a record of every payment made to a creditor or other bill-issuing company that reports to a credit bureau. When a payment is late, a negative mark is added to the responsible party’s credit report, and the credit score is affected. Late payments are usually not reported until they are 30 days or more overdue, though this is not always the case. Payment history makes up about 35% of a credit score.
Credit Utilization Ratio
Credit utilization is the percentage of available credit that is being used, and it’s the second most important credit factor. If a credit card offers a $1,000 line of credit, and an item that costs $500 is charged to the card, the utilization ratio is 50% because half, or 50%, of the total available credit is being used. This gets a little more complicated when there are multiple credit cards involved. Basically, in this case, the total available credit on each card and the total used credit on each card are added together, and a total utilization percentage is calculated. The lower the ratio percentage is, the better.
For example, if three credit cards are listed on a credit report, and they all have $1000 credit limits, the total credit limit for all three cards would be added together, making $3000. If one of these cards is maxed out at $1000 but the other two have $0 balances, the total utilization ratio would be 1000/3000, or 33.3%. If one of the $0 balance credit cards is canceled, the new ratio would jump up to 1000/2000, or 50%, because $1000 dollars of available credit was lost when the card was canceled.
This is why it is not always a good idea to cancel a credit card that has been paid off, especially when other cards that still have balances are still in existence. A good utilization ratio is believed by some to be anything less than 15%, but the lower the ratio, the better. The credit utilization ratio makes up about 30% of a credit score.
Length of Credit History
Length of credit history is how long an individual has been using credit. This usually starts on or near the date that a person opens their first credit card, loan, or other credit account. The longer a person has been using credit, the better. Length of credit history makes up about 15% of a credit score.
New credit is how many new credit accounts have been opened recently, generally within the last six months to a year. When a number of credit accounts are opened at once, creditors worry that this could be because a person is having financial difficulties and may have trouble paying off all of the recently opened accounts. Any more than one or two credit accounts opened within 6 months could send a red flag to the credit bureaus and cause a lower credit score. New credit makes up about 10% of a credit score.
Types of Credit Used
Types of credit used refers to the mix of credit card, auto loan, mortgage, and other loan accounts opened. If only one type of account has been opened, credit bureaus don’t think this accurately represents a person’s ability to promptly pay all types of loans.
For example, even though a person has proved that he or she can pay a $150-a-month auto loan promptly each month, it doesn’t mean the person will do just as well with a $700-a-month mortgage. Therefore, a good mix of credit accounts that are payed on time will help this section a credit score, while simply a credit card or auto loan may not. Types of credit used makes up about 10% of a credit score.
Check credit reports from each bureau yearly to keep tabs on performance in each of the credit areas. A free credit report can be obtained from each of the big three credit bureaus on a yearly basis by heading to annualcreditreport.com.