Credit scores have gained a great deal of attention lately. Advertisements on the internet, television, billboards, and other media have focused in on having a high credit score. But most consumers have no idea what goes into calculating a credit score or what effect credit-related actions will have on their credit score.
The Big Three
There are three main consumer credit reporting agencies in the United States – Equifax, Experian, and TransUnion. Without getting into a lot of historical information and research, suffice it to say these three provide their data to their customers for a fee. Their data is about you … what you owe, who you owe it to, how long you’ve owed it, and a hundred other pieces of information which the credit bureau inputs into their computers before receiving a number at the other end of the process. Each company computes and calculates credit scores using their own “secret” formula, but the fact is they all base their formulas on the same criteria as the big boy on the block – FICO.
Who is FICO?
FICO stands for Fair Isaac Company. The Fair Isaac Company was started up in 1956 by an engineer and a mathematician. By 1958 they had developed a formula which provided a number indicating credit-related worthiness for commercial clients. After 1958, FICO began expanding their credit reporting efforts to consumer credit and they became the largest provider of credit scores in the world. FICO wasn’t the first company to gather and report credit information on a commercial basis, but they were the first company to put the credit info together into a “score” which made it easier for their clients to determine the credit-worthiness of others.
The formula FICO developed was kept a secret for many years. But, as with so many trade secrets, it eventually leaked out. The three consumer credit reporting companies (Equifax, Experian, and TransUnion) got hold of the formula and made it their own, with a few tweaks and changes. This accounts for the difference in credit scores from each of the credit bureaus. Even though each company utilized different weighting criteria for credit info, they all stuck to the same basic formula.
The information included in a credit report is provided by creditors to each of the three bureaus, who pay for the information. The data is incorporated into an individual’s credit history and that information is then used to determine the credit score. Each area of credit information is given different weights when calculating the credit score. The following list details, in general, what percentages of a credit score are calculated for the information submitted:
- 35% Payment history
- 30% Outstanding debt
- 15% Length of time with credit accounts
- 10% New credit information
- 10% Type of credit
Payment History – 35% of the Credit Score
As the largest portion of the formula, the payment history on an individual is extremely important. Late payments, missed payments, underpayments and other issues related to making payments on accounts are all incorporated into this section of the credit score. Some creditors report late payments as soon as 10 days after the payment was due to their offices. Others wait until two payments have been missed before forwarding the information to the credit bureaus. For this reason, it’s important for consumers to understand how each of their creditors reports data to the credit bureaus so they can better manage their accounts with each company.
Outstanding Debt – 30% of the Credit Score
As debt accumulates, the balances are closely monitored by the credit bureaus. Each person has a limit to how much they can borrow. That limit is determined by consumers themselves. If you take out a credit card and run up a $5,000 balance, then pay that balance off, you have proven your ability to service the debt. However, if you take out a credit card and run up a $5,000 balance and only make the minimum payment each month, you’ve demonstrated to the credit bureau you can only pay a small portion of the total debt and you receive a lower credit score as a result. The total amount of outstanding debt (the money you owe) is calculated against the total amount of credit available (unused credit that can be used) and that information is combined with the other data to calculate the credit score. If you make minimum payments on accounts and add additional credit cards in your name, the unused portion of those credit limits will help improve your credit score until you start using up the available credit, at which time the balances will begin hurting your credit score.
Length of Time with Credit Accounts – 15% of the Credit Score
How long you keep an account is a factor in calculating credit scores. The longer you stay with a creditor, the higher your score will be. What becomes important is paying off balances and NOT closing accounts. It is important to pay down the accounts and keep them open. This results in an improved credit score because you have a long relationship with your creditors and you have available credit to draw on. The best thing to do when paying off a credit card or credit account is NOT to close the account. Keep it open and it will help your credit score stay as high as possible. Also, using the same financing resource over and over again for different loans also helps this part of the credit score. In other words, financing three different cars with the same bank or credit union over the years will help your score.
New Credit Information – 10% of the Credit Score
Opening new accounts and the activity on those new accounts is a factor in the scoring formula. New credit, as opposed to older accounts, indicates you have the ability to open up new lines of credit. This is important; it means your financial situation is positive because creditors are willing to loan you money or finance your purchases. It also means you are active financially and not sitting still without acquiring and financing anything. Credit bureaus like people who buy things and pay for them over time. It is ironic to consider that if you made every purchase with cash and never financed anything, your credit score would be very low, despite the fact you can afford everything you purchase.
Type of Credit – 10% of the Credit Score
When you finance your home purchase with a mortgage, that is a loan. When you open up a credit card, that is a loan. When you receive an account which you can charge gas or groceries to, those are also loans. They are all loans, but they are different kinds of loans. Mortgages are a form of financing that is different from a credit card. This difference is important to the credit bureaus. Having different types of credit accounts lets the credit bureaus know you are able to handle different kinds of financing. Installment agreements (like car loans), revolving lines of credit (like department store credit cards), and other types of financing help you achieve a higher credit score by demonstrating your ability to handle the different types of credit lines.
Put it All Together and You End Up with a Credit Score
There are other factors which affect your credit score. For most people, the number for their credit score is between 500 and 800. The lower the number, the less attractive you are to potential lenders. Liens, bankruptcies, judgments, and other negative items can seriously affect the credit score number. Collection accounts, charged-off accounts, and other forms of financing failures also have a negative effect on your credit. The credit bureaus take all the information they accumulate, run it through their unique formulas, and the end result is the number. This number changes frequently with the passage of time and many items, both positive and negative, will cease to be included over time. Positive items remain and have value for a limited time, but negative items can remain in credit reports and affect a credit score for a long time. For this reason, it is important to review your credit reports regularly and take steps to eliminate negative information and enhance the positive data.