What is my credit score and how is it calculated

Introduction

The credit score, commonly referred to as a FICO score, is a tool originally created by the Fair Isaac Corporation. The FICO score is the measure that is most commonly used by lenders to determine the risk involved in a particular loan although it is important to keep in mind that lenders often use their own methods for computing a credit score and these methods can cause your credit score to vary from lender to lender.

There is no exact formula used in the computation of the credit score, but there are five major categories with varying levels of importance that are taken into consideration (with no one area ever being used alone in determining the score).

What is my credit score?

A credit score is defined as, "A three-digit number based on a borrower's bill-paying history and debt profile and statistical information about other borrowers that lenders use to determine the likelihood of certain credit behaviors, including whether you will pay on time." 
Your credit score will have a significant impact on the interest rate you will be required to pay in order to borrow money.

Knowing your credit score allows you to first ensure that all of the information used to calculate that score is correct and secondly can be used to negotiate the best rates with lenders. You can obtain your credit score by requesting it through any credit reporting agency, although it is suggested that you go through any one of the main three (TransUnion, Experian, or Equifax).  Also keep in mind that a credit score is not included in a consumer credit report and must be purchased separately for a reasonable fee.

What do the scores mean?

FICO or credit score range between 300 and 850. Ratings are as follows:

• Excellent: Over 750
  
• Very Good: 720 or more
  
• Acceptable: 660 to 720
  
• Uncertain: 620 to 660
  
• Risky: less than 620

The higher your score is, the better your credit rating will be.  Most credit scores range from around 300 hundred on up to 850 points possible.  The majority of people's scores fall somewhere in the 600 and 700s.  There are very few people who have extremely low scores, and also not very many who have the highest scores or even perfect scores.  The boundary between getting a standard loan product or a sub prime loan is usually around 620.  Anything above is generally considered acceptable and anything below is generally considered very risky.  It stands to reason that the higher your credit score is the more attractive terms and amounts will be offered to you when you choose to purchase something.  It will also be easier for you to keep your credit in good shape as you will have much more available to you.  You will be able to save a tremendous amount of money throughout your life when you maintain a high credit score that qualifies you for low interest rates and better offers than someone else. 

There are many important factors that are taken into consideration to determine what you credit score is and what types of financial products you will qualify for.  Your credit score affects many different things such as your employment, interest rates, insurance premiums and your ability to secure a loan, and all of these make it extremely important to understand how they arrive at a particular score for each person. 

How is my credit score calculated?

The formula used to calculate your FICO score includes information based on several factors.  The best way to ensure a good FICO credit score is to manage your credit responsibly over time. To maximize your score, it's important to understand what goes into the calculation and how much each factor is weighted.  Factors used in calculating your credit score are: your payment history, the amount you currently owe lenders, the length of your credit history, the number of new credit accounts you've opened or applied for (fewer is better), and the mix of credit accounts you have (mortgages, credit cards, installment loans, etc.).

Payment history - 35%

Your payment history is one of the most important factors taken into consideration when determining what your credit score is.  Payment history takes many different types of payments and information from public records and even any bad reports made about a particular person's credit to determine how long they have had credit.  Your history is extremely important because it counts for 35% of your grade.  Imagine doing very poorly on an exam in a class that counted for 35% of your final grade.  You would find that your final grade was influenced very much by this section.  It is of course important to have payment history that shows you have had credit, but it is much better for your report to show that you have good credit history and that you have not had any bad reflections on your report.  This will greatly boost your score.  Your payment history is also time sensitive.  The farther away from today it is, the less it matters to the bureaus.  It is probably better for you to have a few bad reports from 20 years ago while you were in college than to have just one bounced check or late payment in the last few months.  Lenders want to know, of course, that you have had a history of making good on promises made through credit, but they want to be more sure that you will continue to be a good credit consumer and the more recent events on your credit report tell them more about what you are doing now than your old items can. 
 
Amounts owed - 30%

This section of your credit score considers the total amount of money that you owe for all your accounts you have open.  The types and mix of accounts you have is very important as well as having accounts that have low balances compared with the amount of credit available.  It takes into consideration how much of your total credit available you are using on credit cards and other types of revolving credit as well as how much you owe compared to original amounts on installment credit like a car or home.  This section is also very important because it amounts to 30% of your total credit score.  How much you use credit also becomes a factor in this area.  It is better to have multiple accounts of different types with low balances than to have only one or a few accounts maxed out.  Some people say that having one credit card is the best thing you can do for your credit, but this is not true as lenders like to see that you can be responsible with a variety of credit products.  You can determine what your utilization percentage is by dividing your current balance by your credit limit.  This percentage is best kept under 30% for each account to ensure that you are keeping your credit score as healthy as possible.  This is why paying down debt is so good for your credit score improvement efforts.

Credit History - 15%

This section mainly considers the amount of time you have had credit and whether that history is good or not.  Of course having a long credit history with no bad reports is ideal for getting the best credit.  The longer you maintain accounts with creditors the better.  Another bad myth that has come about recently is that if you want to improve your credit score you should cut up all your credit cards and close the accounts as soon as possible.  This may be one of the worst things you could do except under certain circumstances.  It is just fine if you don't use an account, or even better, use it responsibly, but you should still keep it open because it gives you a longer credit history. 
 
Credit inquiries and new credit - 10%

Another section is the amount and frequency of inquiries into your credit.  It is almost always a good idea not to apply for credit accounts you know you don't qualify for.  This can dock your score and you will still not be approved.  What is worse is that you will appear desperate to other creditors and they will be less likely to lend to you in the future as well.  And this is even worse if you have bad credit to begin with or a short or shallow credit history. 
 
Mix of credit - 10%

The last factor taken into account is the mix of credit that you have.  It is good to have multiple types of credit, including installment credit, revolving credit, and other different types.  It is recommended that you not have more than three or four credit cards.  It is also probably a good idea to have no more than two or three installment loans, like cars and homes.  This parameter is even more important if you don't have a very long credit history.