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Credit Scores 101

How Are Credit Scores Determined?

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The exact formula by which credit scores are calculated has yet to be made public. However, according to Fair, Isaac, the developer of the most widely used credit-scoring system, credit scores are based on the following factors, each of which is discussed below:

  • Payment history.
  • Credit Use/ Your Usage Ratio.
  • Your debt/income ratio.
  • Length of Credit History.
  • New Credit.
  • Types of credit in use.

Payment history

Payment history is the most important part of your credit score. It accounts for approximately 35% of your credit score.

  • Accounts that are delinquent, in collection, have late-payments, or were charged-off, will all lower your score.
  • Making payments on time will raise your score.
  • Your most recent history will weigh more heavily than your earlier history, as will multiple incidents of late-payments.
  • Public record items, such as student loan judgments and federal tax liens, are also considered.

Credit use/Your Usage Ratio

Approximately 30% of your credit score is based on your use of credit. FICO considers:

  • The number of accounts on which you owe money.
  • Your average balances.
  • How much of the total credit you have available is being used. This is called your usage ratio. The other ratio lenders look at is your debt/income ratio.

Your usage ratio is the sum of all your credit balances divided by the sum of all of your credit limits. For example, suppose you have four cards with the following outstanding balances and credit limits:

Balance

Limit

Card A

1,000

10,000

Card B

1,000

1,000

Card C

3,000

4,000

Card D

4,000

5,000

Total

$9,000

$20,000

Your use ratio equals $9,000 divided by $20,000, or 45%.

NOTE: It is advisable to at least use a credit card every six months, or even better, every three months. Credit card companies have been known to close accounts because of inactivity. The closure can hurt your credit score by increasing your usage ratio. 

DON'T ATTEMPT TO MANIPULATE YOUR CREDIT SCORE BY CLOSING ACCOUNTS. For example, if you paid off and then closed your Card A account, your usage ratio would actually increase to $8,000 divided by $10,000 = 80%! This could hurt your score more than having one fewer card would help. On the other hand, if you have more than four cards, cancel some.

Your Debt-Income Ratio

Your debt income ratio is the sum of your monthly payments relating to debt plus rent or mortgage payments, divided by your total monthly income before taxes.

For example: Keith has $4,500 per month income before taxes and the following regular monthly debts (which do not include utility and insurance bills, but do include student or other installment loans)

Rent $ 660
Auto loan 450
Credit Card 1 180
Credit Card 2 100
Credit Card 3 40
Credit Card 4 20
Total $1,450

Keith's debt-income ratio is 32.2% ($1,450 divided by $4,500).

Most lenders look for a ratio below 35% or, at most, 45%. Generally, the lower the
debt-income ratio the better the loan terms for the borrower.

Length of credit history

Accounts for 15% of total score.

  • To even have a score, you must have at least one account older than six months.
  • All else being equal, longer credit histories generally increase a credit score.

New Credit

Accounts for 10% of total score.

If you opened or attempted to open a lot of accounts in a short period of time, this can work against your credit score.

Each time you apply for new credit an entry is made in your credit report. Since statistics show that people anticipating financial troubles try to increase the amount of credit they have, this will generally lower your score. However, all inquiries for an auto loan made within a 14-day period, or a 30-day period for a mortgage, are usually treated as only one inquiry. This means it's OK to shop around for the best auto or home loan you can find -- as long as you do it in a short period of time.

Types of credit in use

10% of total score.

While having only credit cards is not necessarily a negative factor, having a mixture of credit (credit cards, consumer loans, and mortgages) may increase your score.

To read more about how credit scores are determined, visit Fair, Isaac's site at
www.fairisaac.com offsite link


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