We’ve talked about what a credit score is and what it’s used for but here we’ll break down how it’s calculated. It’s important to know what factors go into a credit score so that you’re aware of how your actions may affect your financial future. In general, credit scores can range between 250 and 850. Some credit report companies may have a slightly different range but a good credit score to aim for is 750 or higher. These breakdowns are provided by credit report companies that keep track of your credit history but every company may have a slightly different formula.
Payment history looks at previous debt accounts and how well you were able to make payments back on those loans. This is the largest factor in calculating credit scores and is estimated to account for 35% of the calculation. This category also looks at delinquent payments, personal bankruptcy, and whether collections agencies had to go after you. The weight of all these variables differ depending on the types of loans, amount of the loans, the recency of the accounts, and how much of a payment was paid if at all.
Bankruptcy, foreclosure, liens, and collections agencies going after you all have negative impacts on your credit score and are called derogatory marks. These leave a huge dent in your credit score and may take up to a decade to clear the impact. These types of financial events signal to companies that you may have mismanaged your finances before and may be at risk of doing it again.
The second largest category which accounts for roughly 30% of the calculation is how much credit you have available to you versus how much you are actually utilizing. Credit cards have credit limits–the higher the limit, the less risk a credit card company sees in an individual. Also, the less credit utilization you have, the better. High credit utilization signals to a lender that your financial pressure is high and that is why you need to consistently borrow money.
Number of Accounts
If you have many credit accounts, it tells lenders that you have been approved by other companies in the past which indicates your lower risk. However, if you have many accounts for one type of credit, for example credit cards, then this could mean you have had to rely heavily on credit cards due to a financial burden. It is important to remember that every time you apply for a new credit card, your credit score will lower slightly. Therefore, it is best to have various accounts of different types of credit. This different types of credit are called trade lines. Credit cards are considered revolving debt.
The reason it is called revolving debt is because there are no set terms or dead lines to which the credit is available to you. A credit card holder may borrow and repay the debt month after month. The other most common type of credit is called installment loans. This includes student loans, personal loans, auto loans, and mortgages. The amount borrowed is set with an interest rate and a predetermined amount that will be paid back every period.
Soft vs. Hard Credit Inquiries
When you apply for a loan or credit card, companies will look into your credit score to determine whether they will approve your request or not. This is called a hard credit inquiry. Having occasional hard credit inquiries are not too detrimental to your credit score but having multiple all within a short time span will indicate that you are desperately looking for lines of credit and getting rejected. Therefore, it is advised that you apply for loans or cards only intermittently. As time passes between each application for credit, the harm it does to your credit score goes down.
On the other hand, when someone looks into their credit history for a check up. This is called a soft credit inquiry and does not count against your credit score.
How long your credit history is is also very important. That is why a common piece of personal finance advice is to open a credit card account as early as possible to start building credit. The longer the credit history, the better the credit assuming there are no major red flags such as derogatory marks.