In today’s world, it seems we are all defined by a 3-digit number, our credit score! If we have a high credit score, life is easier. We’re able to qualify for lower interest rates, higher borrowing limits, lower insurance premiums, better quality rental properties, and even the American dream of home ownership!
On the other hand, having a low credit score equals the opposite. We end up paying more for almost everything, or not qualifying at all. Since our credit score is such a vital number in our life, it’s important to know how it is calculated.
Credit scores are calculated from the many pieces of data found in our credit report. This data is reported to the Credit Bureaus (Experian, Equifax and TransUnion) by our creditors, and represents how we manage our credit obligations. This data is grouped into 5 major categories and includes both positive and negative information.
Payment History – 35% of our credit score is based on how we pay our bills. Lenders want to know if we paid our existing and past credit accounts on time. Payment history has the greatest impact to our credit score. It is very important that we pay all our accounts within terms. If for some reason we can’t, we should never pay more than 30 days beyond the due date, because this is when our creditor reports us late to the credit bureaus. One 30-day late payment can drop our credit score by more than 100 points!
Amounts Owed – 30% of our credit score is based on the amounts we owe (our debt). This includes all of our installment and revolving debt. The biggest factor in this category is our revolving debt utilization, which is the balance on our credit cards as a percentage of our credit limits. Using a large percentage of our available credit limit hurts our credit score (maxing out our cards). On the other hand, using a small percentage of our available credit limit will have a positive impact on our credit score, as it shows that we are financially responsible. Ideally, this percentage should be 20% or less. Additionally, carrying a small balance on our credit cards will have a more positive impact on our credit score than carrying no balance at all. To maximize our credit score, we should keep our credit card balances low, but greater than $0.
Length of Credit History – 15% of our credit score is based on the length of our credit history. Having a longer credit history will result in a higher credit score. This category takes into account how long our credit accounts have been established, including the age of our oldest account, our newest account and the average age of all our accounts.
Mix of Credit – 10% of our credit score is based on our mix of credit. Those of us who have a healthy mix of installment and revolving credit accounts will have a higher credit score than those of us who don’t. Having a healthy mix of credit types show lenders that we are responsible and able to handle different types of credit. Ideally, we would have 1 or 2 installment accounts (auto, student or personal loan), 3 revolving accounts (credit cards), and a mortgage.
New Credit – 10% of our credit score is based on how often we apply for new credit. Research shows that opening several credit accounts in a short period of time represents a greater risk, especially for people who do not have a long credit history. We should apply for new credit sparingly, only as needed.