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If you're new to credit ratings and credit scores, they may seem complicated, and for good reason. There are calculations involved, several different factors that are taken into account and a variety of companies that can calculate a score for you. To put it in straightforward terms, your credit score is a number that represents how much of a risk it would be to lend money to you.
Since banks and other lenders need to ensure that any money you borrow will be returned, they use your credit score to evaluate how likely it is that you'll default by failing to make payments. If you have a poor history of high debt and failing to pay loans on time, the lender may choose to deny your loan application or charge you very high interest rates.
The best-known and most widely used credit score model in the United States is the FICO® Score. This score, created by FICO (then known as Fair, Isaac and Company) in 1989, has become a standard, used across many different countries and referenced by dozens of international credit monitoring services. While their exact formula is proprietary, FICO has released a breakdown of the data they use when determining your score.
What Goes Into Your FICO Score?
Figure 1: FICO Score Breakdown
- Payment History – 35%
The first thing any lender will want to know about you is whether you can be relied on to pay your bills on time. They look at both past and current accounts to see what your habits are like. If you've forgotten to pay the cable bill a few times it won't completely destroy your rating. However, having a perfect record of on-time payments doesn't guarantee the highest credit score either. Being on time with your payments is definitely critical for a successful loan approval at the best interest rates (and is financially responsible as well).
- Utilization or Amounts Owed – 30%
Credit utilization is the ratio of your current revolving debt to the total credit limit available to you. (Revolving debt includes things like credit cards and lines of credit.) If you have a small amount of debt on a credit card with a large limit, it reflects well on your habits and capabilities. It doesn't look as good if you're constantly maxing out your cards. Keeping your balances low shows creditors that you're a responsible borrower and will only use credit as needed, instead of someone who doesn't manage their money wisely.
- Length of Credit History – 15%
If you're relatively young, you may not have an excellent credit rating simply because you haven't had a chance to prove yourself to lenders yet. Young people without credit cards or student loans haven't had the opportunity to show that they can make payments on time, so their credit scores are lower. If you have a long history of good behavior, your credit score will be higher in this area. When calculating your credit history, FICO takes into account your general banking history, how long certain accounts have been open, and how long it's been since specific accounts were used.
- Type of Credit in Use – 10%
Having a history of managing different types of credit can be helpful to your score. It shows FICO that you can handle a variety of payment structures and varying terms. This includes retail accounts, finance company accounts, credit cards, installment loans, and mortgage loans.
- New Credit – 10%
The FICO algorithm takes note of whether you've done several recent searches for credit, opened several accounts in a short amount of time, or applied for multiple loans. This sort of behavior can be especially harmful to your credit score if you only have a short credit history. This doesn't mean that you shouldn't shop around for the best mortgage rate or auto loan. These typical behaviors will be considered as one hard credit inquiry. (A hard inquiry, sometimes called a hard pull, is a credit check for a loan or for an apartment, as an example. An example of a soft inquiry, or soft pull, is you requesting to see your own credit file.) If you're juggling inquiries on several different things at once, it can appear that you may be trying to take on too much new debt all at once.
How Is Your Credit Score Calculated?
Your FICO score ranges between 300 and 850. Other models, like the PLUS Score from Experian®, range from 330 to 830. It's important to remember that while your credit score is important, it usually isn't the ultimate decision maker for whether you'll be approved for a loan or not. Lenders also take into account factors like your income, how long you've been with your current employer, and the type of loan you need. If you have collateral, like a home or car, this can help offset a lower credit score. AmOne's free service can match you with a trusted, highly rated credit repair, credit monitoring, or identity theft protection provider for your unique situation. To learn more, just fill out our simple credit solutions form or call us toll-free at 1-800-809-1107 to speak with one of our financial search specialists.