Understanding Credit Scores

Anyone serious about increasing their credit scores should first take the time to understand how scores are calculated. By doing so, any effort put forth to increase credit scores is maximized. According to Fair Isaac Corporation (FICO), the percentages of importance in determining credit scores are:

    1. 35% Payment History
    2. 30% Amounts Owed
    3. 15% Length of Credit History
    4. 10% New Credit
    5. 10% Types of Credit Used

Let’s examine each of these categories in more detail to learn more:

Payment History – 35%
In simplest terms, credit that has an on-time payment history is better than credit that’s been past due — we all understand that. However, did you know that an open account that is currently past due is WAY more damaging than an account that has been past due recently but is now current?

An easy way to get a bump in scoring is to get any OPEN accounts that are past due current. However, that doesn’t necessarily mean you want to pay off any open collection accounts. Be sure to speak with your loan officer or credit professional prior to paying off any closed derogatory accounts, since doing so can create documentation issues and actually even decrease your score.

Amounts Owed – 30%
This category is easily the least understood by consumers. Considering the importance (30%) in deriving credit scores, knowing more about how this affects your credit is critical.

The are many different components that make up the “Amounts Owed” category, such as the total debt owed, number of accounts that have a balance, and percentage of credit utilized on revolving accounts. The last one, percentage of credit utilized on revolving accounts, is often times that easiest to manipulate on the consumer’s behalf and therefore can impact scores quickly. To understand more, let’s examine the following scenario:

Consumer A has a $1,000 credit card balance with a $5,000 credit limit. Consumer B has a $1,000 credit card balance with a $1,000 credit limit; all other credit is the same. Which one has a better score? If you guessed A, you would be correct, and the difference would be significant!

Consumer A owes 20% of their limit on this account while Consumer B owes 100%. The scoring models view consumer B as being riskier, given they’re “maxed out” on their credit card. A good rule of thumb is attempt to owe no more than 30% of the limit on any credit card; for example, keep your balance at $300 or less on the card with the $1,000 limit. A good strategy is to continue to pay all bills on time and work with the creditor to increase your credit limits while retaining small balances.

Length of Credit History – 15%
Another straightforward category — the longer you have credit the better your score is and vice versa for shorter credit history.

New Credit – 10%
This category is different from Length of Credit History, as it examines how old (or new) individual accounts are. Older accounts are scored better in comparison to newer accounts. Additionally, new credit inquiries can impact your score negatively if there are an abundance of them. The advice here is to consider keeping open established accounts even if it means retaining a small balance in order to do so.

Types of Credit Used – 10%
Examples of different types of credit include revolving (credit cards), installment, and mortgage accounts. To increase scores, a mix of these accounts normally works best. For example, someone who has only three credit cards accounts would typically have a lower score than someone with a mortgage, installment, and credit card account even if all accounts have the same balance and all are current.

Word of Advice
As always, talk to your loan officer or credit professional PRIOR TO making changes on your credit to ensure you’re making the right choice to increase your credit scores. And remember, you may have to document changes, especially those in which you pay down debt, with proof of how you obtained the funds to make the payment in order to have the improvement in your credit score considered by the lender in the lending decisions.