What is Credit?
We depend on credit for so many important things in life -- whether it's for buying a car, house or computer or getting a student loan. A three-digit number -- your credit score -- can determine whether you can do these things and even how much it will cost you.
How can a simple number determine whether you can buy a house or car? If you've read How Credit Reports Work, you know that your credit report contains a history of how you've paid your bills, how much open credit you have, and anything else that would affect your creditworthiness. Your credit score boils down all of that information to a three-digit number. Using the credit score, lenders can predict with some accuracy how likely the borrower is to repay a loan and make payments on time.
How Your Score is Calculated
Although there are several scoring methods, most lenders use the FICO method from Fair Isaac Corporation. Each of the three major credit bureaus (Experian, Equifax and TransUnion) worked with Fair Isaac in the early 1980s to come up with the scoring method.
A credit score is determined much like a grade in school. Consider how a teacher calculates grades by taking scores from tests, homework, attendance and anything else they want to use, weighing each one according to importance to come up with a final, single-number score. It's the same for a credit score. But instead of using the scores from pop quizzes and papers, it uses the information in your credit report.
The number ranges from 300 to 850. Although the exact formula for calculating the score is proprietary information and owned by Fair Isaac, here's an approximate breakdown of how it is determined:
35 percent of the score is based on your payment history. This makes sense since one of the primary reasons a lender wants to see the score is to find out if (and how promptly) you pay your bills. The score is affected by how many bills have been paid late, how many were sent out for collection and any bankruptcies. When these things happened also comes into play. The more recent, the worse it will be for your overall score.
30 percent of the score is based on outstanding debt. How much do you owe on car or home loans? How many credit cards do you have that are at their credit limits? The more cards you have at their limits, the lower your score will be. The rule of thumb is to keep your card balances at 25 percent or less of their limits.
15 percent of the score is based on the length of time you've had credit. The longer you've had established credit, the better it is for your overall credit score. Why? Because more information about your past payment history gives a more accurate prediction of your future actions.
10 percent of the score is based on new credit. Opening new credit accounts will negatively affect your score for a short time. This category also penalizes hard inquiries on your credit in the past year. Hard inquiries are those you've given lenders permission for, as opposed to soft inquiries, which include looking at your own score and have no effect on the score. However, the score interprets several hard inquiries within a short amount of time as one to account for the way people shop around for the best deals on a loan.
10 percent of the score is based on the types of credit you currently have. It will help your score to show that you have had experience with several different kinds of credit accounts, such as revolving credit accounts and installment loans.
Consequences of Your Score
If you aren't careful about your credit, you could end up paying dearly for a low credit score. Not only can a low score stand in the way of getting a loan for your dream home or dream car, but even if you do get the loan, a less-than-stellar score will make it expensive. As your credit score decreases, you become more of a credit risk in the eyes of lenders. This means they'll attach a higher interest rate to your loan, and your monthly payments will jump. On the other hand, a high score will lower that interest rate.
Can I Change My Score?
Credit scores aren't fixed in stone. Because they're calculated based on your current credit report, they change every time your credit report changes. While this change may be very slight, it can also be much more dramatic. Here are some things some financial advisers say to do to try to improve your score:
Review your credit report and correct any errors you find. A shocking percentage of credit reports contain errors -- one study concluded that as much as a quarter of reports list wrong information that hurt an individual's score [source: CNNMoney]. Getting rid of these negative mistakes can improve a score dramatically.
Keep old credit accounts, even if you're not using them. Creditors look at the debt-to-credit limit ratio and the average age of your accounts.
Reduce your balances on credit cards to 75 percent or less of your available credit (25 percent is preferable).
Pay your bills on time. Assuming that there are no big errors on your report, punctual payments are the most effective way to improve your score. If you look back to the page on credit score breakdown, you'll see that payment history is the most weighty of all elements of your score. This has to do with whether you pay debts back on time and in full. This may take time to raise your score dramatically, but you'll see slow and steady improvement.
Don't let anyone make an inquiry on your credit report unless you absolutely have to. In general, the more inquiries, the lower your score. However, if you are shopping for a loan, make sure multiple inquiries occur within a few weeks, so that they can count as one inquiry on your score.
If you are planning on applying for a big loan, such as a mortgage, don't open new credit card accounts just to increase your available credit in the hopes of raising your score. Opening new accounts will at first have a negative impact. In the long term, however, having more credit available can boost your score.
How Can We Help You?
Your financial health revolves around your credit score, making it imperative that the information your credit report contains is as accurate and up-to-date as possible. Work with our credit experts and proven system to eliminate any inaccurate, obsolete or erroneous accounts... Lower your interest rates, avoid high late fees, save money and advance your credit opportunities.
Understanding how your credit score is calculated and how to read your credit report are the first steps in improving your current standing. Our Credit Education Center offers a wide variety of educational services, credit tips and resources to help you take the necessary steps to enhance your credit score and manage your financial life. Improve your score by identifying the accounts that need immediate attention and why, and understand the impact of the amount of credit you are using.
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