How Credit Scores Are Calculated and Why It Matters

Did you know your credit score can be thought of as your credit “report card?” The most recent Square One Financial Foundations blog discussed the In’s and Out’s of Credit and the importance of establishing and maintaining a good credit history, but how do you know if you’re making the grade?

Credit scores are calculated by several different organizations; however, the big three leading credit reporting organizations are Equifax, Transunion, and Experian.

 

 

 

 

 

The most common scoring model is called the FICO®score, where scores usually range from 300 to 850.  The score is used to help lenders determine how likely you are to pay a loan back. The higher your score, the better your credit history and creditworthiness. Your credit score is calculated using five factors with different weightings, and are broken down by importance below with percentages next to each factor denoting the importance it has in determining your FICO Score calculation:

  • Payment History: 35%
    • Your payment history shows if you make payments on time, how often you have missed payments, how many days late your payments have been, and how recently payments have been missed. For example, if you make a payment more than 30 days late, your lender will usually report this late payment to a credit bureau.
    • Keep in mind, payments made on time have the most significant impact on your credit score.
  • Use of Available Credit: 30%
    • The amount of available credit you use (a.k.a. your credit utilization) is the second leading factor in determining your credit score and shows lenders if you use credit responsibly. Plus, the amount you owe on loans and credit cards is the second largest factor in determining your credit score.
    • TIP: Make sure the balances on your credit cards that are reported to credit bureaus are less than 30% of your credit limit. For example, if your card had a credit limit of $1,000 be sure that any balance reported is $300 or less. Look at your credit history for the date reported to find out when your credit card report balances. Most credit card companies offer free access to your credit score and credit report as a customer benefit.
  • Length of Credit History: 15%
    • The length of time you have been making on-time payments is the next factor determining your credit score. Most credit scoring models will look at the average age of your credit accounts when determining your length of credit history. For this reason, it’s important to keep your accounts open and active. Creditors will close your account after a lengthy period of inactivity, which could negatively impact your credit score.
  • Types of Credit: 10%
    • In a previous blog, we discussed four types of credit. While it’s not necessary to have one of each type, having a healthy mix of credit is the next factor in determining your credit score.
  • Recent Credit Activity: 10%
    • The number of recent inquiries and new accounts added to your credit file also impacts your score. According to FICO® research, opening multiple new credit accounts in a short period indicates a greater credit risk to the lender.
    • It is important to remember that lenders are aware that consumers shop around when applying for credit(i.e. auto loans and mortgages) and will consider this when reviewing your credit file.

Effectively managing the factors that make up your credit score is a crucial step in your journey to financial security. As you can see from the weightings above, making your payments on time and keeping your credit utilization low are the most significant factors influencing your credit score. Still, it’s important to be aware of all the elements making up your credit score. If you’d like some more advanced tips about credit scores, you can also check out this recent article by our founder, Stewart Welch.

 

SquareOne: A Financial Foundations Blog is a personal finance series from The Welch Group created to provide readers with the foundational knowledge to be purposeful with money by identifying key financial concepts that can help them control their financial future. Foundation topics include personal savings strategies, debt consolidation and reduction, life planning, retirement planning methods, and beginner essentials of investing and taxes.

 

certified financial planner Callie Jowers wears maroon and gold zipper dress with hands clasped together, posing for professional photo in an office

Callie Jowers, CFP ®, is an Advisor at The Welch Group, LLC, specializing in providing Fee-Only investment management and financial advice to families throughout the United States. Callie is a graduate of the University of Alabama, is currently pursuing a Master of Accounting at the University of Alabama at Birmingham, and is a Certified Financial PlannerTM.

 

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