Every American knows their credit score is important -- but it turns out there are just five things used to calculate it, and two of them account for 65% of the total score.
Why it matters
Put simply, a person's credit score it is critically important.
Source: www.LendingMemo.com.
Banks and credit card companies use credit scores to decide whether they should or shouldn't make a loan -- like mortgages or credit cards -- but a higher score often means lower rates, and therefore lower expenses. In addition, certain states allow employers and landlords to check credit scores when they make hiring decisions or process rental applications.
Thankfully, though, no matter what a person's score is, it can be improved in just six months, and the first step to doing so is seeing what actually makes up a person's credit score.
What it is
As shown in the chart below, there are five components on the FICO Credit Score: payment history, amount owed, length of credit history, new credit, and types of credit in use. But a person's payment history and the total amount owed make up 35% and 30% of the total score:
Said differently, the combined impact of a person's length of credit history, the types of credit (or loans) they use, and the amount of new credit they have is equal to just their total payments history.
FICO scores account for both positive and negative information from your credit report, so while a history of late or missed payments will lower the score, a score can also always be improved.
Payment History -- 35%
The largest and most significant part of a credit score is a person's payment history, and payments that have been made on time versus those that've been missed or late. It also factors in bankruptcies, foreclosures, lawsuits, and other legal items.
While this is a critical piece, thanks to automatic bill pay and other services, making on on-time payment for the correct amount has thankfully never been easier.
Source: 401(K) 2013 on Flickr.
Amount Owed -- 30%
The second biggest part of the credit score is the total amount owed. Yet this is not simply the total amount outstanding, but the amount of credit used versus what's available.
For example, a person who uses $10,000 of their $50,000 in available credit card balances will be viewed as less risky than someone who utilizes $3,000 of their $5,000.
However, this isn't a call to add credit for the sake of adding credit, as accounts with zero balances can also raise questions, and closing an unused account without a balance that is in good standing won't hurt a person's score.
Length of Credit History -- 15%
Next is the length of the credit history, which looks at the total length of the oldest and newest accounts, as well as the average age of all accounts. Generally, a longer history will mean a higher score, but FICO does take into account the other four parts.
Types of Credit in Use -- 10%
In addition to the length of the accounts used, there is also how many accounts there are, and what makes them up, like credit cards, mortgages, car loans, and other types of borrowing. Exhibiting an ability to manage a variety of different loan types will boost the total score.
New Credit -- 10%
In equal weight to the type of credit used is the number of new accounts opened as well as the number of recent credit checks (not including personal credit checks). FICO notes there is greater risk when multiple accounts are opened in a short period of time, and this is compounded for people without a lengthy credit history.
Improving a credit score can be done, and thankfully, the first step to doing so is understanding what pieces go into calculating it.
