Understanding Credit Scores: How are they Calculated?
Credit scores are calculated using an advanced algorithm. The exact calculations have not been provided by Fair Isaac, the company behind the FICO Score, but they have provided a breakdown of the key areas and that’s what we’ll look at in this guide.
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Your credit score is weighted as follows:
- 35% – Payment History
- 30% – Credit Utilization
- 15% – Age of Accounts
- 10% – New Credit
- 10% – Types of Credit
Payment History (35%)
Whether or not you meet monthly repayments has the biggest impact on your credit score. Miss them and your credit score will drop; enter collections and it will plummet. Meet them and your score will remain strong and steady.
Payment history shows whether you are a responsible lender or not. Can you meet your minimum repayments on time, are you at risk for delinquency? These are the questions that lenders ask.
A solid payment history can help to build an impressive credit score, but there’s still another 65% unaccounted for and it’s possible to have a good credit payment history and a terrible credit score.
Credit Utilization (30%)
Credit utilization is simply the amount of credit available compared to the amount of credit used. It’s an accumulation of debt in relative terms, because what’s significant to one individual could be immaterial to another.
You don’t need to worry too much about the exact calculation, but it can be helpful to turn your credit utilization into a percentage and then use this as a benchmark. As an example, let’s imagine that your debt looks like this:
- Credit Card 1: $10,000 Credit; $5,000 Debt
- Credit Card 2: $20,000 Credit; $10,000 Debt
- Credit Card 3: $5,000 Credit; $5,000 Debt
- Credit Card 4: $10,000 Credit; $0 Debt
- Personal Loan: $5,000 debt
In this case, your total available credit is $50,000 and your debt is $25,000, which means you’re using 50% of what’s available. This is very high and will have a hugely negative impact on this portion of your credit score.
10% or less is an ideal amount, 20% is still considered to be good, but anything above 30% puts you in dangerous territory.
The good news is that this is credit utilization is relatively easy to fix when compared to other aspects of your credit score. The best way to do this is to increase your current limits, thus increasing credit but not debt.
If we return to the above example and imagine a 50% increase on all credit cards then we’ll end up with the following:
- Credit Card 1: $15,000 Credit; $5,000 Debt
- Credit Card 2: $30,000 Credit; $10,000 Debt
- Credit Card 3: $7,500 Credit; $5,000 Debt
- Credit Card 4: $15,000 Credit; $0 Debt
- Personal Loan: $5,000 debt
Your score drops from a high 50% to a much more respectable 37.5%. If you spend a few months increasing minimum repayments to reduce your debts, you can bring it under 30%.
This is also why experts recommend you keep credit cards active even after they have been cleared. If, for example, you clear the debts on Credit Card 1 and Credit Card 2, you’ve lost $15,000 of debt but $45,000 worth of credit, which bumps your score up to 44.4%. If those cards remain active but unused, then it drops to 14.8%.
Age of Accounts (15%)
Time is on your side when it comes to credit. Everything negative will disappear in time, from hard inquires to bankruptcy, and the older your accounts are, the better this aspect of your score will be.
Old accounts that have never missed a payment are very important and account for 50% of your credit score overall. A lot of new accounts will have a temporarily negative impact on your score, but once those accounts have settled and you have proven your worth, then your score will improve.
There’s no way of knowing how long it takes for an account to shift from a negative new account to a positive old one, but the main thing is that you keep meeting those payments while you wait.
New Credit (10%)
This concerns your applications and whether or not you’re applying for a lot of credit. Multiple credit applications infer that a debtor is in financial distress. Of course, there are many other reasons why someone may apply for credit, but that’s why this only affects 10% of your score.
Keep hard inquiries to a minimum and make sure that lenders are using only soft inquiries until you’re ready to acquire new credit.
Types of Credit (10%)
Lenders like to see variety. In their eyes, the best borrowers are those with multiple types of credit, including personal loans, mortgages, car loans, and credit cards. Red flags may be raised if a user has multiple credit cards but nothing else, as it suggests they may have irresponsible spending habits and not have the experience needed to handle multiple types of debt.
This puts borrowers in a bit of a quandary, because while applying for new lines of credit will improve this part of a credit score, it will negatively impact the New Credit section mentioned above, which is weighted the same.
You should never acquire new credit just to improve this part of your credit score. Instead, think about where future credit is coming from. If you’re going to apply anyway, then think about applying for a line of credit different from what you already have.
Got half a dozen credit cards and nothing else? Maybe a personal loan would be wise. Got several loans already? A credit card could help to balance things out.
Conclusion: How Your Credit Score is Weighted
It’s fair to say that credit scores are quite complicated and can be very confusing if you’re new to all of this. The good news is that common sense often prevails and you don’t need to fuss too much about the details.
For instance, simply meeting your repayments every month and being patient with your accounts will maintain 50% of your score. It’s a marathon, not a sprint, but by checking your credit score regularly, and avoiding high-interest rates and hard inquiries, your score will improve in the long-term.