Credit scores play an incredibly important role in modern life. Your score can influence everything, from whether you can qualify for a mortgage, borrow money for a car or even get hired for a job.
However, do you know how your credit score is calculated? Many Americans have no idea.
Understanding what goes into this calculation will help you make better credit decisions.
1. Credit score basics.
A credit score is a three digit number that ranges from 300 to 850. The higher your credit score, the better.
While the exact formulas rating agencies use to calculate credit scores are a secret, we do have a general idea of what they look at.
Your credit score is calculated according to five factors: your payment history, your outstanding debt, the length of your credit history, the type of debts you have and whether you’ve applied for new lines of credit recently.
2. Payment history.
Your payment history is the most important part of your credit rating and makes up about 35 percent of your credit score. For this segment, agencies look at whether you’ve been able to make all your minimum payments on time.
Making on-time payments increases your credit score. However, if you miss payments, it seriously hurts your score. Just missing one payment can drop your score by 100 points.
“Your credit score is calculated
according to five factors.”
3. Outstanding debt.
The rating agencies also place a lot of importance on your outstanding debt. This makes up 30 percent of your credit score.
For this section, the rating agencies look at how much debt you have relative to your credit limit.
If you are close to maxed out, it will hurt your score. To get the best rating, you should keep your outstanding debt to 25 percent or less of your total credit limit.
4. Length of credit history.
The length of your credit history makes up another 15 percent of your credit score. Rating agencies give a higher score to people with longer credit histories.
This is why you should keep your old credit cards active, even if you no longer use them, as old accounts increase the length of your credit history.
5. Type of debts.
Rating agencies prefer to see you have a variety of different loans.
It’s better to have your total debt be a combination of a mortgage, a car loan and credit cards than just outstanding credit card debt. This factor makes up 10 percent of your score.
6. New credit applications.
The last 10 percent of your score comes from whether you’ve applied for more credit recently.
Every time you apply for a new credit card or loan, the lender will pull up a copy of your credit history. The rating agencies keep track of this and if you have multiple inquiries over a short period of time, it will hurt your score.
These factors all combine to make up your three digit credit score. Be sure to work on all five areas so you can get the highest possible credit score.
Photo source: equifax.com.