About half of all consumers know what their credit score is, according to the American Bankers Association .
But how many know exactly how the score is actually calculated? A lot of weight is placed on it.
What is a credit score?
A credit score is a three-digit number generated by a mathematical formula using a consumer’s financial information. According to Bankrate. a credit score is designed to predict risk, specifically, the likelihood that a person will become seriously delinquent on credit obligations in the 24 months after scoring. (Fun fact: There are a variety of credit-scoring models in existence, but most financial institutions use the FICO method. The FICO method is used by Equifax, Experian and TransUnion.)
So how’s the credit score calculated?
A person’s credit score is calculated using information and data from his credit report. The credit report includes a lot of information, but is essentially a file on the consumer, his accounts and his payment history. This includes a record of where he works and lives, how he pays bills and whether he’s been sued, arrested or has filed for bankruptcy.
Data from a person’s credit report is divided into five major categories. The credit score scoring method weighs some of the five categories more heavily than other categories.
Payment history: 35 percent
This includes how timely someone pays his bills — if they are late or on time — and any delinquencies and public records. Payment history is a big one, paying bills on time can do more to raise a credit score than anything else.
Amounts owed: 30 percent
This includes the amount a person owes on all loans, including a mortgage, car or student loans and credit cards. The percentage of available
credit a person is using on revolving accounts, like a credit card, is heavily weighed. For example, if someone is only using $300 of an available $3,000 credit card limit, that will reflect more positively than if he maintains a consistent $2,800 balance on that same credit card.
Length of credit history: 15 percent
This refers to how long ago a consumer opened credit accounts and the time since account activity. The longer a person has an account opened, the more he will go up in this category. According to a creditcards.com article on this subject, it’s best to keep the oldest account open, even if it isn’t being used much. This is especially important if that account’s been opened quite a bit longer than other accounts.
Types of credit used: 10 percent
This includes the mix of credit accounts that someone has. In order to get a perfect score, a consumer needs a variety of types of credit, such as home, auto, student loans or credit cards. This is the lowest-scoring criteria … so if someone doesn’t have a home, auto, student loan, etc. it’s not worth rushing out and getting one just for the credit score. As a general rule of thumb, a person should only establish credit, especially a loan, if he needs it.
New credit: 10 percent
This category can be confusing. Essentially “new credit” includes how often a consumer pursues new credit, including credit inquiries and number of recently opened accounts. In calculating this piece, FICO looks at, among other things, loan applications and new debts that were added to a credit report in the last six to 12 months. If a person has a lot of new credit established recently, he’ll generally be viewed as being “riskier.”