Your Credit Score: How It Works and How to Improve It
Approximately 90% of credit decisions in the United States rely on your credit score as a determining factor.
When I was in college, I would regularly get requests from other students to drive my car. I'd get asked at least once a week, if not more.
You may be wondering, "What kind of car did you have? Ford Mustang? Dodge Charger? Porsche 911 Carrera? It must have been pretty cool if people were always asking to drive it!"
I must admit the answer is quite underwhelming. I drove a silver 2004 Honda Accord. It was a practical, dependable car but it wasn't very exotic. The only reason I was constantly asked about it is because our campus was 2 miles away from anything resembling civilization and only 1 1/2 hours from Los Angeles. They didn't care what it looked like; they just wanted a car!
I told most people "no". And the reason was simple: I wasn't really sure if they would return my car in the same condition it was in when I gave it to them! Basically, the only ones I did lend my car to were the students from my home church. As the "lender", I felt that I could trust them to take good care of my car.
The biggest question any lender has to ask themselves is whether a borrower is trustworthy, or more specifically, creditworthy. Can I trust this person/business/organization to pay back the loan that I give them?
Over the centuries, lenders of all sorts have struggled to accurately gauge the creditworthiness of potential borrowers.
But as lending moved into the 20th century, it became apparent that there needed to be a better, more scientific way to determine a borrower’s creditworthiness. Enter the credit score.
A quick word of clarification is needed. When we talk about “credit score” we are typically referring to a FICO score. There are several types of credit scores out there but the FICO (Fair Isaac Corporation) score is the one predominantly used by lenders.
FICO developed a mathematical formula that would help lenders simplify their loan approval process. This algorithm was designed to take the relevant information about a borrower’s credit history and assign them a credit score on a scale of 300-850. Over the years, the algorithm has been adjusted and tweaked but the purpose is still the same: to help lenders gauge whether a borrower is likely to pay back their loan.
What factors are included in your FICO Credit Score?
1. Payment History (35%)
Do you pay your bills on time? If you pay bills late, how long did it take for you to make the payment? Have you had accounts sent to collections? Have you had bankruptcies, foreclosures, liens, settlements, etc. in the last 7 years? How long has it been since your last negative event?
These are good indicators of your likelihood to pay back the loan. That's why this factor is given the highest weighting.
2. How Much You Owe (30%)
Your credit utilization rate looks at how much debt you owe compared to your available credit limits. Many credit experts recommend that you keep your utilization rates around 10-30% maximum.
For example, if your credit card has a $5000 limit and you make $1000/month in purchases then your utilization rate = 20%. A low utilization rate is going to be looked at more favorably than someone who regularly spends $4500/mo on a card with a $5000 limit. So if you want to increase your credit score it’s important to not be using a high percentage of your credit limits on a regular basis.
3. Length of Credit History (15%)
How long have you been making payments on time? What is the average age of your accounts? A long history of making payments on time is very beneficial to your credit score.
This is the reason why it can be hard for young people to have "excellent" credit. They simply haven't established enough credit history yet. This is also why many credit experts recommend not closing accounts even if you don’t use them anymore. Closing those accounts will lower the average age of your accounts and could cause your credit score to drop.
4. New Credit Accounts (10%)
Applying for a new line of credit can affect your score. Whenever you apply for a loan, there is a “hard inquiry” or “hard pull” on your credit. This means lenders have accessed your credit information as part of their decision-making process.
Opening a new line of credit or having a “hard pull” on your credit will often result in a small drop in your credit score. This is because you may now be a greater credit risk. The reason you have applied for a line of credit could be because you are experiencing financial difficulty or have cash flow problems so the score adjusts to factor in that possibility.
5. Types of Credit (10%)
What types of credit do you have: installment loans, mortgage, line of credit, credit cards, etc.? Demonstrating that you are capable of paying back multiple types of loans can improve your credit score.
However, since this is one of the smallest factors, it would not be advantageous to take on new types of loans just so you could raise your credit score. Whatever benefit you would get from a slightly higher credit score would certainly not outweigh the cost and interest from a new loan.
What factors are not included in my credit score?
· Where you live
· Family size
Lenders may consider some of these factors (income, assets, other liabilities) in addition to your credit score. But by law, some factors (age, gender, race) cannot be used and would be considered discriminatory.
Based on these five factors, your credit score can range from 300-850. Each lender makes its own determination on what they consider to be “good” or “bad” credit scores. But generally speaking, here is how lenders grade these scores:
Borrowers with scores of 740+ are more likely to be approved and more likely to receive the lowest offered interest rates. Borrowers with scores between 580-739 may still be able to be able to get approved but will likely pay a higher interest rate. Borrowers with scores of 579 or below will find it difficult to be approved for a loan. Any loans they do receive will typically have very high interest rates.