"Credit score" is a term that usually evokes something between dread and total confusion.
Everyone knows it’s important, and everyone wants a great one, but ask even your most financially savvy friend how you factor a credit score, and you'll likely get a vague answer or anecdotes about paying on time and not carrying high balances on credit cards.
I’m going to break your credit score down into simple terms that will help you understand what your credit score actually is, how it is calculated, and how you can keep track of this score to meet your financial goals:
What Is A Credit Score?
The main “credit score” is called your FICO score. The name comes from its owner, The Fair Isaac Corporation. While there are many variants of credit scores marketed, the FICO score is the industry standard and is used in 90 percent of lending decisions, according to FICO.
FICO scores are used in a variety of situations to determine if you are “credit worthy” and should be trusted to either repay lent money or pay bills for services extended before you pay for them.
Financial institutions use FICO to determine if they will loan you money, how much money they will provide you, and the interest rate they will charge you for the loan.
Utilities, cable companies and cell phone carriers sometimes use FICO to determine if you will need to pay deposits before beginning service, and some landlords use your credit score to determine if they will rent to you.
Bottom line: Your credit score is an indication of how risky you are perceived to be, based on your past history with financial commitments, and since it impacts almost all of your major life decisions, it is very important.
If you want to borrow money to buy a car or a house on the best possible terms or qualify for credit cards at good rates, you need to know how your FICO score is calculated and how you can monitor it.
How Is My Credit Score Calculated?
There are five broad factors that determine your FICO score, and, therefore, your perceived risk level as a borrower.
Your FICO score is a number between 300 (terrible) and 850 (superb), based on the following factors:
In the ultimate “chicken or the egg” problem, one of the largest factors in your FICO score is your previous credit payment history, which is kind of hard to get without … yea, credit.
Thirty-five percent of your FICO score is determined by your previous payment history.
If you don’t have payment history because you are just starting out, you are deemed risky because they don’t have any evidence to use to determine your score yet.
If you have fallen behind on payments, do your best to communicate with your lenders and get back to being current to help improve this crucial element of your score.
If you have an account, go into collections or file for bankruptcy, you will have “derogatory marks” on your credit that will make it very difficult to get new lines of credit.
The next biggest chunk, 30 percent, is how much of your outstanding credit is being used, called your “credit utilization.”
This is an easy percentage to calculate; take the balance you are carrying on your credit cards and divide it by the total limits on your credit cards.
FICO advises to shoot for between 7 to 20 percent in total utilization on each card and across your total available credit.
Then, the final three factors are how long you have had your lines of credit (15 percent), any new credit you have taken out (10 percent) and the mix of types of credit you have (10 percent).
You want to avoid rapidly signing up for lots of different credit offers, as it’s viewed as risky if you take out many lines of credit simultaneously because you won’t have established payment history on them.
On existing lines of credit, you want to maintain them because the longer you hold a credit line and keep it in good standing, the better this factor will be.
Finally, getting different forms of credit, like student loans, personal loans, credit cards, auto loans and mortgages, and repaying these loans successfully, demonstrates your ability to handle credit reasonably and results in a high score on this factor.
How Can I Track My Credit Score?
Helpful sites like Credit Karma offer free credit score monitoring and a host of other useful tools to manage and monitor your credit score to make sure you don’t get in a negative situation.
Abrupt changes in your credit score can happen if an account you have neglected or forgotten about gets put into collections, or if a mistake is made on one of your accounts.
That’s why it’s important to monitor and take action if your credit score changes dramatically.
Getting and maintaining good credit is a really valuable and virtuous cycle.
The FICO score is just a tool to help determine your risk level, and you are in complete control over the inputs, though you don’t control the score itself.
Now that you understand how FICO is calculated, you can find out where you are and make a plan to improve if you know you want to use credit for a purchase on the horizon.