Understanding Your Credit Score

Your credit score is basically a snapshot of your credit use over the last seven years of your borrowing history. This number (called your FICO score) is based on a complex mathematical model that evaluates many types of information in your credit file. Most people probably have no idea what their credit score is, but it can have a significant impact on your life. In many situations, a lender will base its decision on whether or not to lend you money almost solely on your credit score.

Your FICO score can range from 300 (atrocious) to 850 (perfection).  Anything above 720 is usually considered good.  The average American's credit score is 678, although 11% have credit scores of 800 or above.  Only 1% of the population can boast of a perfect 850 score.

Below are the 5 major areas which are evaluated in calculating your overall credit score and the weight given to that category:

1) Past payment history (35%). Your payment punctuality is the most critical of the factors that make up your credit score. The more recent your tardiness, the lower your score will be. A history of late payments on several accounts will cause more damage than late payments on a single account. Of course, you can greatly improve your overall score by paying your bills consistently on time. 

2) Amounts owed (30%). Add up all of your outstanding balances and compare the number to the amount of credit that is available to you. If you are reaching -- or exceeding -- your credit limits, lenders will be less willing to lend you additional money.  You also want to make sure that the credit extended to you isn't out of proportion with your income. Interestingly enough, your score can be significantly affected depending on when you request it. You can add 20 points to your score the day after you pay your credit card bill (even if you pay in full every month).

3) Length of credit history (15%).  Obviously, the longer your credit history, the more favorable lenders will see you. Your score in this area also takes into account how long it has been since you last used certain accounts.  Just having an idle card for 10 years won't necessarily raise your score. Don't open a lot of new accounts at once to establish a credit history. That strategy will lower the "average account age" on your score, which could affect your score negatively.  In order to get your score into the 800 range, you will need to have at least 10 years of positive credit history.

4) Amount of new credit (10%). Each time you apply for new credit, an inquiry shows up on your report. Red flags start waving when you take on more credit -- or even just apply for new credit -- in a short period of time.  Future lenders do not take kindly to all this readily available credit. They’re afraid you will use it to go on a spending binge, thus quickly undermining standard calculations for determining how much additional debt you can shoulder.

When you shop for new credit (such as a home loan), try to do so in a concentrated period of time. FICO distinguishes a search for a single loan and requests for many new credit lines. (Requesting a copy of your own credit report does not affect your score.)

5) Types of credit (10%). Types of credit include credit cards, retail accounts, and installment loans (like car loans and mortgages).  Though you may be tempted to show what a good borrower you are by using all types of credit, more is not always better in the eyes of credit scorers. If you have had no credit, lenders will consider you a higher risk than someone who has managed credit cards responsibly.

Here are the top factors that make your score lower:

1. Average balance of retail accounts is too high. High credit balances for revolving accounts (credit cards) and some installment accounts (mortgages and auto loans) are considered by lenders to be a negative factor when determining credit worthiness.  High credit balances suggest a sense of living outside your means, which is a high risk for creditors if they are trying to gain repayment. In addition, never using your credit cards is also considered a negative factor because it does not provide lenders with enough information about your creditworthiness. Lenders evaluate how much you owe other creditors in relation to your income.

2. Length of time finance accounts have been established is too short. Open credit accounts over a long period of time are considered a positive factor by lenders, because sufficient credit history can be evaluated as to how you handle your financial responsibility. An optimal credit report will contain about 30 years of credit history. Credit reports with less than 3 years of history are considered not adequate.

3. Too many inquiries.  An "inquiry" is noted on your credit report whenever you apply for new credit. The lender considering your application checks your credit history, which generates an inquiry. Although inquiries are considered common when applying for credit, lenders do not like to see many inquiries within a short period of time. This is because they don’t know if you are just searching for the best deal or if you are becoming financially unstable. It’s often best to limit your credit search to a small number of lenders when searching for the best offer.