For just about any personal finance enthusiast, credit score is the end-all-be-all. For some people, it is step one towards a financial goal, and for other people, it is the sole objective for years. This may sound confusing, but I’ll explain. So what objective exactly? That would be to have a good credit score. What is step one? Using a good credit score to apply for a financial milestone such as a mortgage, auto loan, or more.
If that was even more confusing, then I’ll summarize again. You need a good credit score in order to successfully apply for almost anything financial. Lenders, banks, landlords, and even employers pull your credit to figure out if you are worthy of their time and investment. Think of it this way, the higher your credit score (or the better it is), the greater your chances are of qualifying for one of those milestones I mentioned earlier.
What is a Credit Score?
So a credit score is a numerical value that is assigned to you by a credit bureau. In most cases, your score is defined by the Fair Isaac Corporation (FICO) standard. FICO calculates your score based on various factors that we will cover eventually. This score is the final summarization of your credit and financial history or track record which everyone commonly refers to as creditworthiness. A credit score ranges from 300 (bad end) to 850 (amazing end). Judging by my parentheses, you want a score that is closer to 850.
What Determines a Credit Score?
As mentioned earlier, FICO calculates your credit score, or FICO score if you will. There are five commonly mentioned factors that determine your credit score.
The first of these is payment history which factors into your score with a weight of 35 percent. Your payment history technically involves any on-time/late payments, bankruptcy filings, or judgements on a credit card, mortgage, student loan, auto loan, or any account carrying credit. This metric also takes into account the length of time since your most recent payment infraction (late or insufficient).
The next most significant factor (weighted at 30 percent) is how much you currently owe; in other words, this is how much debt you have in total. This involves the total magnitude of your debt, but it also takes into account the proportion of this debt to available credit. Let’s say you have $5,000 in debt overall with an overall credit limit of $10,000. This will be measured differently compared to someone with $7,000 of debt with a credit limit of $20,000. The technical difference here is credit utilization. The first debtor has a utilization ratio of 50 percent while the second debtor is utilizing 35 percent of his or her credit. As a good rule of thumb, you want your credit utilization ratio to be around 30 to 40 percent depending on your sources.
Next up is the length of you credit history which is considered at a factor of 15 percent. This is how long your accounts have been open, and it includes how long theses accounts have been active.
Weighted at 10 percent, new forms of credit represent another credit score determinant. By new credit, I mean the number of new accounts you open relative to the number of accounts you already have open. Additionally, the time since your last newly opened account is taken into consideration.
The final factor (on this list at least, I can’t really assert that it’s the fifth and final factor; in fact, I don’t think anyone really can say that. It’s controversial.) involves the different forms of credit that you have open (weighted at 10 percent). This refers to the mixture of account types such as mortgages, credit cards, auto loans, student loans, etc.
Taking all of these factors into account, FICO determines your credit score for you! Of course, FICO isn’t the only company out there to measure credit worthiness. But for now, they are a decent standard to use when learning about credit score. When you sum up these five factors, you should get 100 percent!