How Is A Credit Score Calculated

Unravel the mystery of the number which controls your financial life.

Having good credit can determine everything from having a good interest rate on a loan to whether an employer hires you. Do you ever wonder how a single number, your credit score, can have such a big effect on your life. Not only that, you have probably asked yourself one time or another, how is this mysterious number is determined. Well lets unravel the mystery of the number that rules your financial life.

What exactly is a credit score?
It is a three digit number that is an indicator of how likely you are to repay your loans. Its derived from the information in your credit report. So your credit report is words, and your credit score is numeric like an SAT score.
The anatomy of a credit score is this:

Payment History – 35%
Amounts Owed – 30%
Length of Credit History – 15%
New Credit Applications – 10%
Mix of Credit – 10%

In years past these percentages use to be a secret, open to speculation. The Federal Government a few years ago pressured the credit agencies to open up how the calculate the credit score the let people have some information about how they work. Now lets see each one of these factors of your credit score in detail.

Payment History
This is the one with the largest impact for obvious reasons, because of course how you pay your bills and obligations in the past is probably a good indicator of how you will pay them in the future. Lenders are look at whether you paid them, whether you paid them on time, and when was the last time you paid late, if ever.

Amounts Owed
Sometimes this term is called credit utilization ratio, its not really about how much debt you have total. What they care about is the amount of debt you have, compared to the amount of debt you have been approved for. That ratio is all-important, which sounds weird to most of us, but that’s what they determine is the best indicator of someone who is credit worthy and capable of taking on more debt. Its bad to be maxed out or near your credit limit, that really dings your score. So its important to keep in mind, that although you have a very large limit, its important to not get anywhere near that in the amount of credit you are using. In fact, if possible, stay below 10% of your credit limit, especially with your credit cards.

Length of Credit History
For some this factor is a little more frustrating, because it is 15% of your score but you don’t have much control over it. Most of it is your age, how long you have been in the working world, and how long you have had credit cards. They have figured out that people who have had credit cards for a longer time and who are a little older are typically more stable and more likely to pay their obligations in the future. This is why they made it part of the score.

New Credit Applications

Of all the factors, this may be the most confusing of its relevance to your ability to pay your loans, and your credit score. Its a catch-22 because its good to have credit, but they penalize you for applying for new credit. The key is, don’t apply for a bunch of credit cards all at once, which can raise red flags as to why you need to take on as much debt at one time. They don’t like borrowers who appear desperate and in need of a lot of money they don’t already have. You can apply for multiple car loans and mortgages because those are considered differently. Every car loan or mortgage you apply for in a 45 day period is considered one, because they understand you have to shop around for the best interest rates.

Mix of Credit
This is a factor that is also ambiguous but what the credit agency wants to see that you have multiple sources of credit granted, such as a mortgage, car loan, credit cards, etc. You shouldn’t necessary try to artificially have this mixture, but that it will happen naturally throughout the course of your life.