Understanding Your Credit Score

Your credit score is an important piece of your financial life. Many people understand that their credit
score will be taken into account when they apply for credit. Common examples include applying for a
mortgage, car loan, student loan, credit card, etc. However, your credit score can also be checked by cell
phone companies, utility companies, retirement communities, and even potential employers. It quickly
becomes clear that this three digit number can be seriously impactful. The issue is, the vast majority of
people can’t explain the basics of how your credit score is calculated. Something so influential on your
financial life shouldn’t be a mystery; so today we will lay out the five factors used in determining your
FICO score.

Your credit score is determined by the Fair Isaac Corporation (hence “FICO” score). While the Fair Isaac
Corporation has not provided the public with an exact calculation for credit scores, they have provided
the five categories that make up the score, as well as their respective weights in the process. These
categories are payment history (35%), amounts owed (30%), length of credit history (15%), new credit
(10%), and credit mix (10%). It should be noted that the weights in parenthesis are averages, and can be
adjusted slightly to more accurately represent different groups (i.e. young vs. old).

Payment history is the factor most expect. This category focuses on what percentage of your payments
do you make on time vs. not. Lenders are very interested in whether or not you pay your obligations on
time with consistency. It should be noted, if an established borrower with a perfect payment history
accidentally makes a late payment or two, this will not instantly demolish your credit score. Nor will
paying everything on‐time for decades mean you automatically end up with an 850 (the perfect score).
Payment history is just one piece of the puzzle.

Amounts owed (or “credit utilization”) is the next most important factor. This portion of your score
evaluates—based on your credit profile—whether you are using too much credit. A borrower who is
using too much credit is seen as overextended and thus more at risk of missing future payments. Some
items included here are: percentage of your credit used on revolving accounts compared to your limits,
how much is owed on installment loans compared to the original amount, how many accounts have
balances, etc.

The third most important factor in your credit score calculation is the length of credit history. If your
accounts are all decades old, that shows stability lenders like and helps your score. If most of your
accounts are 2‐3 years old, you are going to be looked at as more high‐risk because the longevity is not
there. The calculations do try to take into account borrower age. If you are a younger borrower with a
short credit history, but everything else looks great—your score will be dinged less than someone who
has many new accounts at sixty years old.

The next factor is credit mix. Credit mix is tied for last in weight (importance), but it still gets factored
into the calculation nonetheless. Credit mix means lenders like to see a variety of types of credit on your
report. It is better to have a mortgage, a retail account, an installment loan, and a credit card than it is to
have four credit cards. It should be noted, that it is never advisable to open accounts you don’t need.
That said, if you score well on the other sections (like payment history), your score will be higher if you
have a variety of account types as opposed to just a handful of credit cards.

Lastly, we have the factor called new credit—which is tied in importance with credit mix (10%). This
portion includes how often you apply for and open new credit. If someone opens four credit cards in a
six‐week span, that is going to be a red flag that negatively affects your score. That said, there are folks
who develop a very real fear of ever having your credit pulled because of the effect it will have on their
credit score. This is an unnecessary fear for most people. Credit inquiries drop off your report in 12
months, and as long as you are not applying for credit once a month for an entire year, they have a
minor effect on your score.

Asking “how do I improve my credit score” is a question millions of people ask every year. The first step
to improve your score is understanding the factors discussed in this piece. Once you have a grasp on the
five pieces that make up a credit score, you can develop a plan to improve specific areas that might be
holding your score back.


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