Your Credit Score: How is it Calculated, Why Does it Matter?

If you finance a car, apply for a credit card, or rent an apartment, they’ll review your credit score. But what is this mysterious rating? And what does it tell them?

First and foremost, your credit score is important because it reflects financial health. Creditors use someone’s score to estimate their ability to pay debt and how responsible they’ve been with repayment in the past. Since those with higher credit scores are offered better interest rates, having a high score can lead to significant savings over the course of your life.

Our credit (or FICO) score can also impact how much we can borrow, and when it needs to be repaid. Building (or repairing) one’s credit score requires time and effort. Destroying it, on the other hand, can be done in an instant.

There are quite a few myths and misconceptions about what is and isn’t helpful when it comes to building and maintaining good credit.

Let’s clear up some of that confusion…

Credit Score Ranges

Credit scores start at 300 and go to 850.

They’re ranked as:
Poor (300-579)
Fair (580-669)
Good (670-739)
Very Good (740-799)
Excellent (800-850)

How is it Calculated?

FICO scores are determined using multiple factors. These metrics are weighted, meaning some matter more than others. Additionally, the three agencies that calculate scores have slightly different criteria.

They’re listed here in order of importance. Payment history and amount owed will have a larger impact than credit type or newness.

PAYMENT HISTORY

Someone who’s never made a late payment has an excellent payment history. One late payment drops their rating to good, two or three to fair, and four or more to poor.

AMount Owed (CREDIT USAGE)

I’ve come across quite a few people who aren’t clear about the impact of credit usage. Some believe you’ll have a higher FICO score if you leave a balance from month to month, that you’re penalize for paying your card off in full. This is FALSE!

Others have heard that you need to spend a certain amount on your credit cards each month to raise your score. Again, totally FALSE!

Credit usage refers to the proportion of total available credit you’re using.

To rank as excellent, you must use less than 9%. Using from 10-30% is considered good, 31-60% fair, and more than 60% poor. Put another way, with a credit limit of $1,000, your balance shouldn’t exceed $300.

Amount owed indicates, at least indirectly, your remaining credit. It makes known what you have readily available for use.

Length of CREDIT HISTORY

Someone with accounts that were opened at least 25 years ago has excellent credit history.

A rating of good is assigned to those who’ve had accounts for between eight and twenty-four years. Those with five to seven-year-old accounts are ranked fair. Poor indicates a credit history of less than four years.

This is why people are often told to hold onto their oldest credit card, even if they no longer intend to use it. It’s also why parents add children as authorized users on their credit cards, even if they’ll never be allowed to use them.

New Credit (CREDIT INQUIRiES)

Hard inquiries, which typically show that you’ve applied for credit, can have a minor impact on your score for a year or two. To rank excellent, you can’t have had any credit checks in the recent past. If you’ve had one or two, that is good. Three to five inquiries brings you down to “fair”, and having had six or more is poor.

Types of Credit USED

This category also considers debt collectively, from mortgages and various loans to credit cards. When it comes to your credit score, not all debt is considered equal. Both the type of debt and repayment duration matter.

A fifteen-year mortgage or subsidized student loan is typically classified as “good” debt (FYI – it pains me to write that), three-year car loans and 30-year mortgages are “reasonable”, and a 7-year car loan or ongoing credit card balance is “bad” debt.

Raise Your Credit Score!

To improve your credit score – make consistent, punctual payments, reduce total debt, use no more than 30% of the limit on your credit cards, and pay your card balances off (in full) each and every month.

If you’re consistently going over thirty percent, and you’re paid multiple times a month, try paying off your credit card every time you get a check (rather than when the bill is due).

Remember, negative reports resulting from late payments (or nonpayment) stay on your credit for up to seven years.

When it comes to debt, barring very few exceptions, less is more, none is ideal.

The best way to stay on top of your payments is to create a spending strategy (budget) and stick with it!

Oh, I almost forgot… Check your credit score annually to make sure there are no reporting errors. It’s also a great way to protect yourself from identity theft!

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