How your credit score is calculated

I’ve never been big on obsessing over your credit score. My theory is that if you have good, sensible financial habits, then your score will follow. There are plenty of people out there who will show you how to manipulate your credit score in order to make it go up, but what’s the point? Who are you really tricking? If you have a high score, but a terrible financial situation, then you lose. You’ll just trick someone into loaning you money, despite the fact that you shouldn’t be lent money. This is bad for you, not them.

The purpose of a credit score is to measure your risk of default. Although the exact formula for calculating a credit score isn’t know, we do know there are various factors with various degrees of importance. Below, you will see how FICO (Fair, Isaac, and Company) begins to determine your score.

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35% Payment history– Are you making payments on time? I hope so. There isn’t anything more basic than paying your bills on time. Pay your bills on time and your score will remain in a decent place.

30% Amounts owed– If you your credit limit is $5,000 and your balance is $3,500, then your score is going to take a hit. This concept is called credit utilization. If you have too much of your total credit in use, your score will go down. If your credit line increases, then your credit might actually improve. For instance, let’s say you have $3,000 limit with a $1,700 balance. If your limit is increased to $10,000, then your credit score would go up because you have a better utilization ratio.

15% Credit history– Did you file bankruptcy? Did you have an account in collections? You can try and justify these things however you like, but you aren’t the ideal credit risk if you have a spotty credit history. People often wonder whether or not they should close a credit card they’re not using. Closing a card is likely to hurt your credit score, but that doesn’t mean you shouldn’t do it. If your credit is solid, and you don’t have a need for it (you don’t), then close it. Having a bunch of store credit cards open will do more harm than good, in the long run.

10% Inquiries, new credit- When your credit is run several times, in an attempt to borrow money, your credit score can take a hit. The more inquiries there are on your credit, the more your score goes down. Don’t ever have anyone run your score unless you know you are going to buy from them.

10% Types of credit in use- If I can be honest, this one is stupid. I was recently told by my mortgage company that I should open a store credit card and a major credit card (Visa, MasterCard, etc) in order to improve my credit. My credit score is very very good. In my opinion, the mortgage company is giving dangerous advice. While it would technically improve someone’s score to have diverse types of credit, the benefit would be minimal because this factor is only 10% of the score.

So there it is, good or bad. Do smart things to improve your credit. Pay bills on time. Don’t wildly seek more credit. Don’t let accounts go into collections. You can’t get too bent out of shape about a bad credit score. Your default solution to any problem shouldn’t be to borrow. Besides, if you make every decision based on your credit score, you’ll actually end up with a tremendous amount of debt.

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