Credit scores seem to be one of the biggest sources of mystery and myth on the face of the planet. They are the financial equivalent of the Bermuda Triangle or Bigfoot. In fact, I would say that it’s the single largest subject I continually hear people give bad advice about.
Since your credit score has a huge effect on your budget, it’s important to understand exactly how it is calculated and how to take care of it. Let’s start by looking at how your FICO credit score calculation actually breaks down.
35% – Payment History
30% – Balance-to-Limit Ratio
15% – Length of Credit History
10% – Types of Credit Used
10% – Recent Applications for New Credit
So, let’s define these terms a little further…
The single largest portion of your credit score calculation comes from a simple question: “Did you pay all your bills on time?”
Someone with an occasional “30-day late” payment will not see their credit score affected too much. But, if you start piling on more 30-day late payments, or any 60-, 90-, or 120-late payments, prepare to watch your score plummet.
The second largest component of your credit score comes from the total amount of available credit that you’ve used. If you have a $2,000 credit limit, but have only used $1,000, your ratio is 50%.
Generally, your credit score is affected negatively as your balance-to-limit ratio climbs, as well as the total dollar amount of your available credit. Also, lenders often use balance-to-limit ratio benchmarks (such as 33% and 50%) to decide if someone is too risky for a new loan.
Length of Credit History:
This category is one of the biggest myths with credit and one of the things I’m constantly trying to get people to avoid. The myth? That you need to “build credit.” In fact, the length of your credit history is only 15% of your overall score.
If you do not have a long enough credit history, a lender is ultimately going to look at your income to see if you can cover the payments. College kids and young couples do not need to worry about building credit. It backfires more often than it helps!
Types of Credit Used:
Certain types of credit are thought to indicate risky spending patterns more than others. For example, someone who is constantly signing up for credit cards at mall retailers appears impulsive.
If they were to have $5,000 in balances on these cards, it would be viewed more negatively than someone with $5,000 in student or auto loans.
Recent Credit Applications:
Lenders are always on guard for red flags; some indication that you might be a credit risk. If someone all of the sudden applies for a dozen different credit cards, it may be a signal that they are in the middle of a financial crisis.
Now that you know the basics of calculating your credit score, check back for part two of this series, which will cover checking and protecting your score.