How is Your Credit Rating Determined?

Why is it important to know how credit scores are calculated?

The primary reason to know and understand how your credit rating is calculated is to help you learn what actions to take or avoid in order to keep your rating as high as possible. If you have a low credit rating, understanding how it’s calculated can help you determine what problems you should correct in order to improve it. Understanding how your score is calculated also helps with your financial planning by allowing you to take in account the effects of any given action on your credit rating.

FICO

In the United States, FICO is the leader of the credit-rating industry and each of the “Big Three” credit reporting agencies – Equifax, Experian, and TransUnion – use various FICO-developed systems to calculate credit scores. The exact formula used by each of the Big Three are proprietary secrets, but FICO gives a basic outline of what factors are taken into consideration and what importance they have in the calculation.

Payment history

The most important factor in calculating your credit score is your payment history. This is the record of your payments to creditors.Your payment history shows also whether payments were timely. Defaulting on outstanding debts, missing payments, and making payments late are all part of your payment history. In general, this element constitutes 35% of your credit score, which means that having a bad payment history is the worst thing that can happen to your credit rating. Most notations related to payment history remain on your credit report for seven years, regardless of whether the debt has been paid or settled.

Credit usage ratio

Your credit usage ratio is a comparison of the amount of credit you have immediately available to the amount of credit you have actually used. The more unused credit you have available, the higher the score. This is a slightly tacky metric because it only considers your open credit accounts, so paying off an account and closing it can hurt your score. Having a lot of open credit accounts, but keeping them paid down, will boost this portion of your score. Your credit usage ratio is usually weighted at about 30% of your score.

Length of credit history

The third factor, the length of your credit history, counts for about 15% of your credit score. The purpose to credit scores is to give lenders a clear view of your habits when it comes to paying off debt, so the longer your history, the more information for lenders to consider. This is a factor that the consumer can’t really affect in a meaningful way, but it suggests that it is to your benefit to start establishing credit as soon as people. The less history, the less valuable your credit score has to lenders.

Types of credit used

The various types of credit a persons uses are also taken into consideration, with diversity of credit being viewed favorably. If you only have one type of loan, like a revolving credit card account, this portion of your score will be lower. Having a diverse array of debt – credit card debt, non-revolving bank loans, a car, mortgage and so forth – will increase this part of your score, because it tells lenders you can manage several types of loans. The types of credit you have used constitute about 10% of your score.

Recent credit inquiries

Although credit scores are used for other purposes than applying for new loans, the FICO system generally assumes that recent credit checks mean you are actively applying for credit.  If there are several recent inquiries, it is assumed that you have been trying to borrow from multiple lenders and this is viewed negatively. The more recent inquiries, the lower this part of your score is. This factor is weighted as about 10% of your credit score.

How is this information helpful?

By understanding how credit scores are calculated, you can make more informed and more prudent decisions that can improve it. For instance, since your usage ratio is so important, when you pay off a credit card account, it might be better to leave it open and just ignore it, rather than closing it.  Likewise, when you’re presented with the choice of applying for an additional loan to keep other obligations current, or missing payments on an existing loan, understanding how the score is calculated can help you make a better decision about the right course to take.