A person’s credit score is a bit of a snapshot of their financial history. With a multitude of factors influencing the overall rating, called a FICO score, credit reports can be a bit of a mystery as to how they are calculated. The general premise is simple, however, and should be well known for the fiscally conscious. To know the ins and outs of keeping a healthy credit score is the key to receiving access to better interest rates and more credit availability.
What is a Credit Score?
In a nutshell, a credit score is a numerical rating as to how trustworthy the score holder is in terms of lending. A higher rating will show that the score holder is a person with a strong background of borrowing and repaying, and in general knows how to deal with loans. Conversely, a lower credit score shows that the individual either does not have much experience with lending and repayment practices, or has proven to not be capable of repayment in the past. Having a lower score will block individuals from acquiring loans with lower interests rates and of larger amounts. This can affect purchasing a home, a car, a general purpose loan, or any other countless financial activities.
What Affects a Credit Score?
There are only a few major factors that are taken into account when a FICO score is generated. These different statistics give an accurate snapshot of how willing a borrower is to repay loans responsibly and effectively. The biggest factors are:
Responsible for roughly 1/3 of a person’s FICO rating is payment history. This mainly involves paying borrowed money back on time and in sufficient amount. Borrowed money can include credit cards, home loans, and vehicle loans to name but a few. For a borrower, showing lenders that they are going to receive the previously specified payments in a timely manner will have an enormous impact on credit ratings.
Negatively impacting factors in terms of payment history include bankruptcy, foreclosures, and liens on a borrower’s property. All of these show that the borrower was not willing or able to repay previous debts and had to be forced to comply with the loan agreements. For financial institutions looking to lend money to a person who has declared bankruptcy in the past, the institutions will be significantly less confident that they will receive their money back in a reliable manner.
Accounting for approximately 30% of a credit score is the amount of total debt owed. The amount a person owes to lenders of all types versus how much credit they have access to can be a major implication of whether or not a person can manage their debt effectively. For example, if a borrower has a credit limit of $5,000 on a card but only $500 in debt, they will show that they are able to responsibly use their card. If that same person decides to pay all of their bills and maxes out their credit card, however, it has a good chance of lowering their FICO score. This all has to do with how a lender can perceive the responsibility of a borrower.
-Length of Credit History
Younger generations will typically have more difficulty securing loans, but not because of their age directly. As previously mentioned, a FICO score is essentially a trust assessment, and young persons who have no history of paying debt will not have an accurate indicator as to whether or not they will follow through with loan agreements. Length of credit history is not as major as the previously mentioned factors, as it only accounts for roughly 15% of a FICO score. While 15% is not an insignificant amount, length of credit history is something that can only be increased slowly over time by responsibly borrowing and paying off debt.
-New Lines of Credit
A very common variable in terms of credit scoring is new credit. When calculating a FICO score, credit institutions typically view borrowers who rapidly open multiple lines of credit as people who are either struggling financially or are expecting to take on a large amount of debt. This can range from either applying for multiple credit cards within a short time period or having credit checks performed while applying for mortgage or vehicular loans. When a mortgage lender is looking at a potential borrower to determine their viability in terms of interest rates and loan amounts, they will be more wary if multiple recent credit lines have been established.
-Multiple Lines of Credit
When a FICO score is being generated, only about 10% of the overall score is affected by having credit from multiple sources. When comparing a borrower who has one source of credit to a borrower who has multiple sources from different institutions, the latter will be considered more trustworthy. A person who manages to pay off a home loan and multiple auto loans will obviously be more well versed in lending practices than a person who has one unused credit card. Multiple lines of credit is not one of the factors that has the most impact, but is still something to consider for those looking to expand their credit report while thinking of future investments.
What Does Not Affect a Credit Score?
There are several factors that have nothing to do with a FICO rating that may not be obvious. A few of these factors include:
- Monthly income – while lenders do look at monthly eligibility for payments, they are more focused on willingness to pay loans back rather than capacity.
- Age – credit age is a factor, but a debtor’s age is not. This leaves young people at a natural disadvantage, but only a minor one.
- Gender – the gender of a debtor is not able to be reliably determined by credit reports, and is not a factor.
Knowing how to manage a credit score is an enormous leg up for would be homeowners, car owners, and anybody seeking to afford major items without having to pay cash up front. To know how a FICO score is determined is to know how to better take advantage of it, which means better interest rates and lower monthly payments. Taking into account the major factors listed above and applying them on a month to month basis is a sure fire way for a borrower to live within their means while consistently increasing their credit rating.
- What Makes Up My Credit Score?
- Credit Score
- FICO Score
- Qualifying Ratio
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- Why Did My Credit Score Drop?