Lenders use credit scores to determine how likely it is that you will pay your debts on time. If you have a good credit score, you are more likely to get loans or credit cards with lower interest rates. So how is your credit score determined?
For many years we learned that banks or businesses would decide whether to grant you credit based on the three C’s of Credit: Character – Have you used credit before and paid it off on time? How long have you been at your current home and job? Capital – What assets do you own? Capacity – Are you able to repay the debt based on your current income and debt you already owe?
Once we entered the Internet Age, banks and businesses no longer research your credit history themselves. There are three major credit reporting agencies in the United States who keep track of all the debt you’ve had and how you make your payments: Equifax, Experian, and TransUnion.
Based on the information from the credit reporting agencies, companies calculate your credit score. FICO, the most common, stands for the Fair Isaac Corporation. FICO was a pioneer in developing a method for calculating credit scores based on information collected by credit reporting agencies.
There are five main factors that impact your FICO score.
· 35% of your score is based on your payment history, whether you pay your bills on time.
· 30% of your score is your credit utilization ratio. This is how much debt you owe compared to how much you could be using. The lower this percentage, the higher your credit score.
· 15% is determined by the length of your credit history. Generally, the longer you’ve used credit or kept a specific credit card, the higher your score.
· 10% of your score is based on how much new credit you have opened recently, including hard inquiries from companies where you have applied for credit.
· 10% is based on your mix of credit: credit cards, installment loans, mortgage, etc.
FICO gives everyone a credit score between 300 and 850. 800 or higher is exceptional and these people get great loan rates! 740-799 is very good. 670-739 is good, and the average credit score is in this range. People with a FICO score over 670 probably have no trouble getting loans. 580-669 is a fair rating, and these subprime borrowers pay higher interest rates. 579 or lower is considered poor and people in this range are usually rejected for credit.
How can you improve your credit score? You have to pay your bills on time! Every time! If this is a problem, consider setting up automatic payments through your bank. Then don’t get close to your credit limit. You don’t want to be over 30% of your credit limit on your credit cards, so you should never max them out. Try to pay them in full every month. Don’t carry multiple credit cards; a Visa, Mastercard, or Discover card should allow you to charge anywhere. Only apply for credit that you need.
Once a year, and before you take out a large loan, you should check your credit history. You are entitled to a free credit report every 12 months from each of the three major consumer reporting companies (Equifax, Experian and TransUnion). You can request a copy from AnnualCreditReport.com. You can check a different one every four months. This won’t affect your credit score. If you spot an error, let the company know.
Credit scores are not based on your income, or on whether you live in poverty or wealth. They are based primarily on whether you pay your bills on time!