Consumers are aware that their credit score is the result of a mathematical equation which utilizes various pieces of data from their credit information. What most consumers don’t understand is which data is important and which is less important.
The Big Kahuna in Credit Scores
There are several credit rating bureaus in the United States. Some of them provide credit ratings for businesses or other groups. The main player in the credit rating game is FICO. The name FICO stands for the Fair Isaac Company. Engineer Bill Fair and mathematician Earl Isaac started the company in 1956 and by 1958 they were publishing their first credit ratings for companies. Since that time, FICO has become the leading credit rating agency in America providing over 90% of all credit scores published today.
The Little Kahunas
Equifax – The oldest credit rating agency in the United States was founded in 1899 as Retail Credit Company. Since then, the organization has grown and adapted to the modern age of computers. Primarily used to convey credit information about individuals to client companies, Equifax remains a major factor in credit rating bureaus.
TransUnion – Founded in 1968 as Union Tank Car Company, TransUnion began its move into the credit rating business with its purchase of the Credit Bureau of Cook County in 1969. Since that time, the company has acquired many other major-city credit rating companies and now has 250 offices worldwide.
Experian – A British company at its outset (CCN systems), it purchased the American company TRW Information Systems in 1996 and became a global credit rating agency in the ensuing years.
The “Formula”
For many years, no one really knew how the credit agencies calculated credit scores until FICO let out its secret. Since that time, most credit raters use the same basic formula to calculate the credit scores of tens of millions of consumers, but each has its own twist to the numbers, which is why each consumer ends up with three different numbers. The general concerns and weighting of the data is:
- 35% Payment history
- 30% Outstanding debt
- 15% Length of time with credit accounts
- 10% New credit information
- 10% Type of credit
35% – Payment History
This is the major factor for credit calculation. Determining when payments were made, whether on-time or late, and if any time extensions had to be granted by the creditor. The payment amounts and quantity of payments made are also considered. Bankruptcies, tax liens, and other negative factors are included in this category.
30% – Outstanding Debt
The capacity of a consumer to handle debt is calculated based on the amount of debt the consumer currently holds and how much more debt that can be added to it and still be serviced properly. The FICO scoring processes gives positive reactions to consumers who pay down their debts, then charge up the debt again before paying it down once more. The scoring process is less-favorable toward consumers who pay off debts and close accounts, rather than leaving the account open with a balance available. It’s a little confusing but FICO likes seeing credit activity happening on accounts because it helps them score the consumer’s performance and there’s no scoring-data benefit to a closed account.
15% – Length of Time With Credit Accounts
The amount of time a consumer (debtor) works with each credit provider (creditor) is given a value. Long-term loans paid off on time and in full are pure gold. Mortgages, auto financing, home equity lines of credit (HELOC) and other longer-term financing arrangements show up as a positive factor in calculating a credit score. Financing on different accounts from the same creditor are important too. For example, buying three cars and having them financed over time by the same credit union on different notes helps the debtor receive a higher credit score.
10% – New Credit
This factor speaks to any new credit accounts that are set up, new credit cards that are received, and other credit resources accessed in the near-term. New accounts can actually be more of a negative than a positive on a credit score, showing the consumer is using up available credit. Additionally, “hard inquiries” can negatively affect a credit score. Hard inquiries result from applications for credit submitted by a consumer. “Soft” inquiries, like those from employers, pre-qualification credit card marketers, and other sources making inquiries without the consumer’s permission, aren’t given any weight toward calculating a credit score. Many consumers like to shop around for the best loans, like autos, homes, and other high ticket items, and the rating formula doesn’t penalize consumers, provided all the inquiries are made within a two-week to 45-day time-frame.
10% – Type of Credit
Utilizing different types of credit arrangements is a more positive influence on ratings than only using one type of credit. For example, a consumer with revolving lines of credit, installment loans, traditional credit cards, and other forms of credit agreements will receive a higher rating than a consumer with only credit cards. A consumer’s performance with each type of financing is calculated against other consumers with similar experience, determining the factor to be used in calculations.