Do you understand what a credit score is? Most people don’t, except that they know they have one and that high is good and low is bad. First we’ll try to explain what it is, and then what you can do to affect it below.
Credit scores are an easy way for banks and other companies that lend money to know if a person is a good or bad credit risk, so a high score generally means that you will pay back money that you borrow on time. They’ve boiled down all of this information into a single number, usually between 300 and 800.
The whole system of credit scores is pretty recent. In the 1960s credit cards were becoming popular and each bank (or other credit card issuer) was trying to determine whether someone was a good risk or a bad risk using a different method. Eventually the government got involved in the various systems, which were often inconsistent or inaccurate.
The basis of the system that we use now throughout the United States was developed by Fair Isaac and Company in the 1980s and is called the FICO score. It’s based on five factors: payment history, outstanding debt, length of time you’ve had credit, how much new credit you’ve recently acquired, and what kinds of credit you have.
Here’s how each of those factors influences your score:
- Payment history (35% of your score is based on this): The biggest weight is your history, how many bills you’ve paid, how many of them were paid late, and how many of them were sent to collection. If there are problems, the more recent the problems are has a bigger negative impact on the score.
- Outstanding debt (30% of your score): The second largest factor is how much debt that you use. Generally it’s understood that this is a curve. If you are maxed out on your lines of credit or if you’re using none of it, your score will be lower than if you constantly use some of your credit and pay it off on time. The sweet spot is probably about 25% or less of your credit limits.
- Duration of credit (15% of your score): Generally, the longer that you’ve had a credit score the higher it will be. Unless you never pay your bills or default every other week, that is.
- Adding new credit (10% of your score): When you add several new lines of credit that tends to hurt your credit in the short term. So getting credit cards and loans at the same time will hurt you now, but as you pay them off on time your score will recover and grow.
- Breadth of credit (10% of your score): Having different kinds of credit, say a house loan, a car loan, and a credit card all at the same time, will tend to increase your credit score.
A FICO score isn’t the only thing a lender will look at, and there are other kinds of scores that rely on different factors in different proportions. Generally though, the five factors listed here are a good basis to understanding where the various single number credit scores are coming from.
Now that you know what your score is made up of, here are some recommendations on what to do about it:
- Monitor your credit. It’s important to regularly check your credit score. You’re entitled to a free credit report every year from the major agencies (like Experian or TransUnion) but be careful! There are a lot of websites that will charge you money. The real website for free credit reports is www.annualcreditreports.com (See also here.)
- Correct errors. Agencies are required to have a policy and a procedure for correcting errors and disputes. Even if you fix something, it can take years for your corrections to take effect.
- Pay your bills on time.
As accountants though, if you’re trying to improve your credit score, we can help with that.