WHAT GOES INTO CALCULATING YOUR CREDIT SCORE?
Feb. 11, 2018
Banks, car dealers, mortgage companies, and any business that relies on consumer lending love credit scores. They use them to make their lending decisions easy. If they had to independently rate every customer themselves, they would have a difficult time keeping up with a high volume of business. The credit scoring system allows them to sell that car or create that credit card account right away.
Consumers can improve their credit scores by strategically planning their credit use to create a stronger profile. To do this, understanding what scores are comprised of is crucial. Here is what you need to know.
How credit scores are calculated
Fair Isaac, the company that created credit scoring, keeps the exact formula private; however, due to consumer and governmental demand, it has provided a general framework by which people can understand what goes into their credit score's calculation. This information provides valuable assistance to people who wish to improve their credit ratings. By knowing what goes into the formula, consumers are able to make credit decisions in ways that improve their scores.
Scores are composed of the borrower's payment history, outstanding debt, length of established credit, amount of new credit accounts, and types of credit accounts. Each of these factors contributes a percentage to the calculation of the credit score. For example, credit history makes up 35 percent of the score's calculation. The score works similar to the way teachers calculate students final grades.
35 percent of you score depends on how promptly you pay your bills. The formula deducts for late payments, accounts in collection, and past bankruptcies. When accounts that are in collection are paid off, some of the deduction is reduced. This is also the case with accounts that are passed due. The longer a bankruptcy occurred in the past, the less it affects the score.
This comprises 30 percent of the score. It is nearly as important as payment history. Though it may seem that payment history is vastly more important than outstanding debt, in terms of credit risk, the two are very close in significance. Even if a person has a good payment history, a high amount of outstanding debt indicates he or she has fallen into a debt situation that has become unmanageable.
It is important to remember that outstanding debt takes into account the percentage of a person's credit lines that are in use, not the dollar amount. One person may have $2,000 in debt. If their total credit lines add up to $5,000, this amount of debt hurts their score. Another person may have $2,000 in debt and total credit lines of $100,000, which the formula considers a positive.
Length of credit history
In this category, older people have a distinct advantage. The formula uses length of credit history as the basis for 15 percent of the score. Fair Isaac reasons that people with long credit histories are a safer bet than those who have just started using credit. Also, it favors those with lots of long-standing accounts versus those who have closed older accounts in favor of newer accounts.
10 percent of your credit score is affected by opening new accounts. New accounts bring down scores temporarily. For those with little credit history, opening new accounts still benefits their score because they need to establish credit with good payment histories and credit limits.
Types of credit
What kind of accounts you have matters for 10 percent of your score. Mortgage debt and auto loans are better than credit card accounts. Credit card accounts are better than payday loans. Accounts that reflect a stable financial position, such as a mortgage, make you attractive. Payday loans and too many credit cards indicate financial distress.
Another important factor to remember are hard pulls. Hard pulls are the credit checks run by credit card companies, auto dealerships, and lending institutions. Hard pulls are negative because too many indicates a person is trying to take on a lot of debt. A series of hard pulls in a short time, such as by several auto dealerships on a person who is car shopping, do not bring down scores. Neither do soft credit pulls, which are checks on your credit score that you did not authorize, such as those used to prequalify customers for credit card promotions.
Credit scores provide convenience. They allow lending institutions to make rapid credit decisions. They also allow consumers to avoid long loan application processes. By working to create a credit profile that raises their scores, consumers can make credit shopping much easier and receive better credit offers.
Credit Score Help in Savannah
For specialized advice on your financial situation, debt counseling can provide a stress-free alternative that saves then a lot of money. Contact Georgia Debt Relief today for a free consultation!