Credit Reports - How Your Credit Score is Calculated and Its Implications
Your credit score is included on most credit reports viewed by creditors and potential creditors. It is essentially a numerical calculation that indicates your creditworthiness and the risk you might default on your payments. Your ability to get a loan and at what interest rate is directly tied to your credit score. Knowing what factors feed into this calculation can give you the ability to more actively manage the perception of your financial reliability.
Fair Isaac is the largest and most recognizable credit scoring company and they developed the formula for the FICO score. To calculate your score, details about your credit history, such as how many accounts you have, your payment patterns, and collections activities against you, are collected and compared to similar profiles. Your are awarded points depending on how you stack up. A low score therefore indicates higher risk. A high score is preferable and indicates lower risk. We'll look at each of the variables that go into this calculation next.
Payment History Highest points are earned for paying debts on time, no delinquent accounts, and no history of bankruptcy. This factor comprises about 35% of the total score.
Amounts Owed Basically, the higher percentage of your available credit you have used up, the lower your score. About 30% of your score depends on this factor.
Credit History About 15% of your score is derived by how long you have maintained credit overall. As you might guess, longer is better.
Established vs. New Credit A lot of recent new accounts are not considered a good sign. Nor are a large number of recent inquiries on your account. Both lower your score because they indicate you are looking for new credit and might pose a higher risk,
Types of Credit This comprises approximately 10% of your score and the most points are earned when you have a variety of different types of credit, such as credit cards (revolving credit) and installment payments (mortgage or car loans).
Inconsistencies Abound Your credit score can differ from one credit bureau to another depending on the formula used to generate it, the information that was considered, and even for whom the report was created. Each of the credit bureaus has slightly different information on you and uses different formulas to emphasize different aspects of your credit history as required by various lenders. This leads to the inconsistency in credit scoring numbers.
Most lenders agree that a FICO score higher than 750 is considered very good. However, a few years ago the three major credit card companies introduced an alternate credit scoring system called VantageScore, which uses both a numerical and letter rating. In addition, some lenders rely on their own system to assign you a credit score. All these competing systems really put the consumer at a disadvantage when it comes to monitoring and maintaining their credit score.
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