Improving Your Credit Score: What is it and how is it calculated?
13 July 2006This post is Part One in a series of posts on how to improve your credit score.
The very first step you’re going to have to do is figure out whether you’ve got good credit or not right now. You probably have a vague general idea – if you haven’t been paying your bills, or if you’re up to your eyeballs in debt, it’s probably bad. If you’re financially responsible and pay everything on time, always, it’s probably good.
As always in life, however, things are more complicated. Even if you don’t know it, all of your financial relationships with various companies – the company that loaned you money to buy a car, your bank, your credit card company – are constantly being compiled into a credit report – a background of information on you and your dealings with others that lets prospective lenders know about your financial history. They use this information to help them decide whether or not to lend you money – and if so, how much it’s going to cost you.
A credit report is a big, detailed report on your prior actions. It’s got a list of every payment you’ve ever made on any loan or credit card, including whether it was on time or not. It also keeps track of how much credit you have available, how many credit cards you have, how many times you’ve tried to get a loan, and tons of different things you may not even know about yourself.
A credit score is a number that represents how good or bad your credit history is. This is what most companies will use when deciding whether or not to lend to you – it’s a short, simple summary of the pages and pages of data that are in the full report. There are several different companies that compile scores, and they each use slightly different methods. The biggest three are Equifax, Transunion, and Experian, and it’s important to get your report from all three.
What is the range for credit scores?
Credit scores are also called a FICO score, named after the company that developed it – Fair, Isaac, and Co. The highest score is 850. The lowest possible score is 300.
The average score is around a 720. Very few people get above 800 – only 10-15% of the population, so if you check your credit score and find out you’re above that level, you don’t have much to worry about.
Your goal should be to keep your score above 740. This is a common cutoff for special deals and better interest rates on cars and mortgages.
If your credit score is below 700, then you have some work to do. Once you get below that level, your rates start to go up, often very dramatically. You will pay more every month for your house, your car, and your credit cards than a neighbor with better credit. The good news is that there are many small changes you can make to your financial life that will produce big improvements in your credit.
What’s a good credit score and what’s a bad one?
Generally, below 600 is considered bad. Above 720 means you’re above average, and is a good score.
How are credit scores calculated?
No one knows exactly. The companies that calculate them keep their formulas secret – but they do release the basic outlines to the public. Technically, you have three different credit scores published by each of the major companies, and they will not be the same.
Fair Isaac, or FICO, is the major score and the most important one. They have released a basic outline of what goes into the scores:
35% of the score is calculated based on your prior debt payments and how punctual they were. Paying debts on time increases this portion.
30% of the score is calculated based on the ratio of your current debt to how big your credit limit is - or in other words, how much you owe right now compared to how much you could borrow if you maxed out all your credit cards. If you aren’t at the limit of your credit cards, your score will be higher than if you max them out.
15% of the score is based on the length of your credit history. Longer is better.
10% of the score is based on the types of credit you use. It’s not really clear what this means, however.
10% of the score is based on recent searches for credit – you don’t want too many people searching for your credit score too often, because it looks like you’re out trying to get as many loans as possible.
It’s important to understand, however, that this is a very simplistic statement of the scores – and it doesn’t include everything. For example, a bankruptcy will plainly hurt your credit. But FICO has not explained exactly how this affects the score. The actual way of calculating the score has hundreds of factors and varies depending on how old you are, how deep your credit history is, and other unknown variables.
It is, however, a good guide to the general things you should be doing to keep your credit score higher.
How do I get my credit report?
There are a number of different companies you can use online to get credit reports. You are entitled by law to a free credit report from each of the three agencies once per year. However, to find out your actual credit score, you will have to pay. One you can take a look at is http://www.myfico.com/.
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3 Responses to “Improving Your Credit Score: What is it and how is it calculated?”
July 14th, 2006 at 3:25 pm
[...] This post is the second in a series on improving your credit score and cleaning up your credit history. Part One dealt with the basics of what a credit score is, how it is calculated, and how you can request a credit report. This part deals with your first step: making sure there are no mistakes in your credit history. [...]
July 21st, 2006 at 2:46 pm
[...] This post is part three in a series on improving your credit score. Part One dealt with the basics of what a credit score is, how it is calculated, and how you can request a credit report. Part Two gave advice on how to correct errors in your credit report, so that you can fix any problems that aren’t your fault. [...]
July 21st, 2006 at 5:48 pm
[...] This post is part of a series on how to improve your credit score. Part One dealt with the basics of what a credit score is, how it is calculated, and how you can request a credit report. Part Two gave advice on how to correct errors in your credit report, so that you can fix any problems that aren’t your fault. Part Three dealt with changing the way you pay your debts each month so that you make sure you always pay your bills on time – and minimize damage to your score if you don’t. [...]