How is my credit score calculated?

How Is My Credit Score💡 Definition:A credit score predicts your creditworthiness, influencing loan rates and approval chances. Calculated?

Understanding how your credit score is calculated can be a game-changer for managing your financial health. Your credit score, a number between 300 and 850, serves as a snapshot of your creditworthiness💡 Definition:A credit rating assesses your creditworthiness, impacting loan terms and interest rates.. The higher the score, the lower the financial risk💡 Definition:Risk is the chance of losing money on an investment, which helps you assess potential returns. you present to lenders. But what exactly goes into that crucial number? Let's break it down.

The Five Components of Your Credit Score

Your credit score, specifically your FICO score💡 Definition:A three-digit credit score (300-850) calculated by Fair Isaac Corporation, used by lenders to assess creditworthiness., is calculated using five key factors. Each contributes differently to the final score, influencing how lenders view your creditworthiness.

Payment History💡 Definition:Payment history reflects your record of on-time and late payments, influencing your credit score significantly. (35%)

The most significant component, your payment history, looks at whether you've paid past credit accounts on time. This factor alone comprises 35% of your score, underscoring its importance. Late payments, defaults, and bankruptcies can drastically lower your score, while a consistent record of on-time payments can enhance it.

Amounts Owed (30%)

Also known as credit utilization, this measures how much credit you're using compared to your total available credit. Ideally, you want to keep your credit utilization below 30%. For instance, if you have a total credit limit of $10,000 and a combined balance of $3,000, your utilization ratio💡 Definition:The percentage of available credit you're using, calculated by dividing total credit card balances by total credit limits. is 30%. Lowering this percentage can positively affect your score.

Length of Credit History (15%)

This factor considers how long you've maintained your credit accounts. It looks at the age of your oldest account, the newest account, and the average age across all accounts. Generally, a longer credit history can boost your score. However, even new credit users can achieve high scores by maintaining good credit habits.

Credit Mix (10%)

Lenders prefer to see a variety of credit types, such as credit cards, auto loans, and mortgages. This diversity, or credit mix, accounts for 10% of your score. It demonstrates your ability to manage different types of credit responsibly.

New Credit (10%)

Opening several new credit accounts in a short period can be risky, as each application results in a "hard inquiry" on your credit report. This factor, which includes your recent credit applications, accounts for 10% of your score. It's advisable to space out credit inquiries to minimize their impact.

Real-World Examples

Consider Sarah, a 28-year-old with two credit cards, an auto loan, and a newly opened credit line for her small business💡 Definition:A small business is a privately owned company that typically has fewer than 500 employees and plays a crucial role in the economy.. Her payment history is flawless, yet she notices her credit score dropped slightly after opening the new line of credit. This is likely due to the "new credit" component, which temporarily lowers her score due to the recent hard inquiry.

On the other hand, John, a 35-year-old with a long credit history, maintains a credit utilization of 25%. Despite having a couple of late payments years ago, his score is high due to a long history of diverse credit types and consistent, low utilization.

Common Mistakes and Considerations

Ignoring Credit Utilization: Many consumers focus solely on making payments without considering how their balances affect utilization ratios.
Opening Multiple Accounts at Once: While it may seem like a good idea to increase available credit, multiple hard inquiries can negatively impact your score.
Neglecting Older Accounts: Closing older accounts can shorten your credit history and reduce your overall credit mix.

Bottom Line

Your credit score is a vital financial tool, and understanding how it's calculated can help you make informed decisions. By focusing on timely payments, keeping balances low, maintaining a diverse credit mix, and being strategic about new credit, you can enhance your credit score. Remember, your credit score is dynamic, reflecting your latest financial behaviors and decisions. Regularly monitoring your credit report can help you stay on track and make adjustments as needed.