"The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is fear of the unknown."
-- H.P. Lovecraft
Your credit score doesn't materialize out of thin air. It comes instead from a formula that balances five variables: payment history, current debt load, length of credit history, new lines of credit, and the types of credit you currently use and have used in the past.
The purpose of the calculation is to determine the likelihood you'll repay your debts. The more likely you are to do so, the higher your score. The less likely, the lower your score.
Now, there are two ways to look at this. You can lament that such an important aspect of your life is determined in a cold and detached manner. Or -- and this is the approach I recommend -- you can capitalize on it by mastering the process and exploiting it.
Assuming you choose the latter, the primary key to improving your credit score lies in understanding how it's calculated. Once you've acquired this knowledge, you'll be able to identify the steps needed to mend or otherwise increase it.
With this in mind, the following chart illustrates the weighting that credit-reporting agencies give to each of the five variables that affect your score.
The most important factor is your payment history, which accounts for 35% of your final score. If you're seeking to improve your credit profile, in other words, this is the place to start. "The moral of the story is to pay your bills on time," says FreeScore.com.
The variable with the second highest weighting is the amount of money you currently owe. To be clear, there is no "right" number. The credit agencies look rather at the percentage of a person's available credit that's being used, as well as how many different credit lines are open and the balance of each.
The third most heavily weighted factor is the length of your credit history. Makes sense, right? The longer your history of prudent credit use, the more trustworthy you are, so to speak, from a financial perspective. This is the reason older people generally have better credit scores than younger people.
The fourth variable considers recent credit-related activity. This includes things like credit inquiries and the number and type of new credit lines. According to myFICO.com, "[R]esearch shows that opening several new credit accounts in a short period of time represents greater risk -- especially for people who don't have a long credit history."
Finally, the fifth factor looks at the types of credit used. Do you have revolving accounts like credit cards? Installment loans such as a car payment or mortgage? Do you trade on margin in your brokerage account? How wide this diversification is and how adroitly you manage the different types has a 10% impact on your score.
Ultimately, the key is to use these five factors to your advantage. No good general goes into battle without first learning about the opponent and terrain. And the same can be said about improving your credit score. The credit agencies are your opponent; their methodology is the terrain. Now that you know both, it's time to attack!
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