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How Your Credit Scores Are Calculated - The 5 Main Factors You Need To Know
When most of us think of scores, we think of the relatively straightforward systems used in sports or in school tests. You get points for certain actions, behaviors, or answers; and those are totaled to determine your score.
Credit scoring isn't nearly so easy. Credit-scoring models use multivariate formulas. That basically means that the value of any given bit of information in your report might depend on other bits of information.
To understand how this works, let's use a noncredit example. Say that your sister calls you to report that her husband is more than an hour late in coming home from work, and she asks if you think he's having an affair. To answer the question, you would need to review what you know about this man, including his attitude about his family, his general moral standards, and whether he's had dalliances in the past. Using all these variables, you could try to predict whether your brother-in-law is likely to be stepping out, or might just have stopped off to buy his wife an anniversary present.
The number of factors that the FICO formulas evaluate is infinitely greater, so you can see how difficult it can be sometimes to predict the outcomes of certain behaviors. There's one thing that's always true, though: The FICO model is set up to place more value on current behavior than on past behavior. That means that the effect of your old credit troubles lessens over time if you start handling credit more responsibly.
It's generally a lot easier to lose points on your score than it is to gain them back, which is why it's so important to know how to improve and protect your score. Now that you understand in general how credit scores are calculated, we can move on to some specifics. The following are the five main factors that affect your FICO score according to their relative level of importance.
1. Payment History
This makes up about 35 percent of the typical score. It makes sense: your record of paying bills says a lot about how responsible you are with credit. Lenders want to know whether you pay on time and how long it's been since you've been late, if ever.
More than half of Americans don't have a single late payment on their credit reports, according to Fair Isaac, and only 3 in 10 have ever been 60 days or more overdue in the past seven years.
There's a definite "hierarchy of badness" when it comes to your credit score. A payment that's 30 days late isn't considered as serious as one that's 60 or 120 days late. Collections, tax liens, and bankruptcy are among the biggest black marks.
2. The Amount You Owe
This equates to 30 percent of your score. The score looks at the total amount on all accounts (credit card, auto loan, mortgages, and so on). Most Americans use less than 30 percent of their available credit limits, according to Fair Isaac. Only 1 in 7 uses 80 percent or more of available limits.
As you might expect, using a much higher percentage of your limits will worry lenders and potentially hurt your score. People who max out their credit limits, or even come close, tend to have a much higher rate of default than people who keep their credit use under control.
3. Length of Credit History
This is 15 percent of your total score. As such, it's generally much less important than the previous two factors, but it still matters. You can have a good score with a short history, but typically the longer you've had credit, the better. The average American's oldest account has been established for about 14 years, according to Fair Isaac. One in four has an account that's been established for 20 years or more.
4. The Types of Credit You Have and Use
This is 10 percent of your score. The FICO scoring formula wants to see a "healthy mix" of credit, but Fair Isaac is customarily vague about what this means. The company does say that you don't need to have a loan of each possible type - credit card, mortgage, auto loan, and such - to have a good score. Furthermore, you're cautioned against applying for credit you don't need in an effort to boost your score, because that can backfire.
To get the highest possible scores, though, you need to have both revolving debts (like credit cards) and installment debts (like an auto loan, mortgage, or personal loan). These latter loans don't have to still be open to influence your score. But they do still need to show up on your credit report.
5. Your Last Application for Credit
This is 10 percent of your overall score. Opening new accounts can ding your credit score, particularly if you apply for lots of credit in a short time and you don't have a long credit history.
How these five factors are weighed when it comes to you - as opposed to the general population - depends on a little-known sorting system known at Fair Isaac as "scorecards." Scorecards allow the FICO formula to segment borrowers into different groups, based on information in their credit reports. After the model has this information, it decides which of the scorecards to assign. Although Fair Isaac keeps the details pretty secret, it's known that there is at least one scorecard for people with a bankruptcy in their backgrounds, and another for people who don't have much information in their reports.
Grouping people this way is supposed to enhance the formula's predictive power. The theory is that the same behavior in different borrowers can mean different things. Someone with a troubled credit history who suddenly opens a number of accounts, for example, might be seen as a much greater risk than someone with a long, clean history. Scorecards allow the FICO formula to give different weight to the same information.
About the Author Chris Esposito specializes in home renovation loans for people who wish to buy and fix up a home with a home improvement project or a full, major rehab. For more information about home renovation loans, go to www.DirectRehabLoans.com, or call (877) 876-3688.
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