Do you remember a time before credit scores? Now credit scores are used by lenders, credit card companies and even some landlords to determine your credit worthiness. Although there are several different companies that offer scores, the FICO (Fair Isaacson Corporation) is the most popular.
There are five key components that determine your overall score. The most emphasis, 35% of the overall score, is based on your payment history which shows if you pay on time. Being late, missing payments or going into default will lower this part of your score.
The second largest component, 30%, is credit utilization, which means how much you owe in relation to the amount of credit you have available. If you have a $4,000 balance on available credit of $20,000, this would be a 20% ratio and would be considered acceptable. If you owe $15,000 on $20,000 of available credit would be a 75% ratio and would would reduce this part of your credit score. According to FICO, people with the best scores average around 7% credit utilization.
The length of time each account has been open and the account’s activity determines 15% of the total credit score. By having a longer credit history, the credit provider has a better indication of the your long-term financial behavior. However, having an open account without any activity doesn’t offer a provider much information.
New credit and types of credit each account for 10% of the total score. New credit can adversely affect your score because it is a new obligation without history of how it will affect your ability to repay. Types of credit include both revolving (credit card) and installment (student loan) debt. A good mixture of each can indicate less risk for lenders.
The combination of all five areas make up the total score which lenders use to determine your credit worthiness. Another confusing issue is that all credit scores are not mortgage credit scores. This particular score determines not only whether the lender will give you a mortgage but at what interest rate.
Whether you’re looking to buy or sell in the near future or not, it is important to know your credit score. Hopefully I’ve helped to demystify how your credit score is determined.