When it comes to making credit decisions, most lenders use the FICO scoring model. Unfortunately for consumers, the exact formula that determines your score is a closely guarded secret.
However, the Fair Isaac Company does give some general guidelines that can help us optimize our own credit scores. Specifically, there are five categories of information that make up your credit score, ranging from your payment history to the amount of new credit you've been applying for.
Here are some ways you can make the most of each of the five categories and increase your own credit score as much as possible.
How FICO scores work
FICO credit scores range from 300-850, and higher scores are better. Most consumers have scores between 500-800, and anything over 740 or so is generally considered to be excellent credit.
The whole purpose of a credit score is to estimate your future credit risk, and higher scores represent lower default risk to lenders. For example, according to myFICO.com, borrowers with FICO scores between 759-799 have just a 2% chance of becoming seriously delinquent on a credit account within the next two years. For borrowers in the 600-649 range, this risk rises drastically to 31%.
This is the most important contributor to your score, making up 35% of the total formula. Fortunately, it is also the easiest to figure out.
Basically, lenders want to know that you've paid your bills on time. This part of the formula takes into account your payment history on credit cards, installment loans, mortgages, and other credit accounts. Also included in this category are account types that can result from non-payment of your bills, such as collection accounts, judgments, foreclosures, and bankruptcies.
Now, while a collection account or foreclosure can destroy your credit score, one or two late payments in an otherwise solid credit history won't necessarily have a devastating effect. The best way to improve in this category is to simply make all of your payments on time from here on out.
30% of your score is made up of the amounts you owe on your various credit accounts. However, this doesn't necessarily refer to the dollar amounts.
Instead, the "amounts owed" category emphasizes how high your balances are relative to the amount of available credit you have. And, it takes into account how much you owe on your installment loans relative to the original balance.
For example, if you have a total of $5,000 in available credit on your credit cards and have balances totaling $2,000, you are using 40% of your available credit. On the other hand, if you owe $10,000 on your credit cards, but have $50,000 in available credit, you are only using 20% of your available credit, which actually looks better in the FICO formula.
So, the best way to improve in this category is to pay down your credit cards, and keep the balances low. Be careful when closing credit cards you don't need anymore, as it will lower your available credit and increase the percentage of your credit that you're using.
Length of credit history
All other things being equal, a longer credit history will improve your FICO score. In fact, the length of your credit history constitutes 15% of your score.
This category takes into consideration the age of your oldest account (even if it's no longer open), as well as the average age of your credit accounts. If you've opened a lot of new credit accounts recently, the average age of your accounts is probably pretty low.
Things like how long specific accounts have been established and how long it's been since you used certain accounts also play a role here.
The best way to improve in this category is to open new accounts only when you need them. The longer your average credit account has been open, the better.
This category counts for 10% of your score, and it is pretty self-explanatory -- don't open too many accounts in a short time period.
Research has shown that doing so represents a greater risk, so too many new accounts (or credit inquiries) can hurt your score.
The FICO score considers inquiries from the last 12 months ; as a rule of thumb, try to apply for new credit only once or twice per year. Don't let this discourage you from shopping around for the best rates on mortgages or auto loans. As long as the inquiries happen within a short time period, they will just count as a single inquiry for scoring purposes.
Types of credit used
Lenders want to see that you can be responsible with a variety of credit accounts, and the mix of credit accounts on your report determines 10% of your FICO score.
For example, if you have a flawless payment history on your mortgage and student loans, but these are the only two accounts on your credit report, it can actually hurt this aspect of your score.
If you don't have any credit cards, you may want to consider opening one and using it occasionally, just to add some variety to your credit history. According to myFICO, people with no credit cards tend to be viewed as a higher risk than those who have credit cards with a solid history of responsible usage.
Look for a card with no annual fee, and it shouldn't cost you a dime to do this. Just charge an everyday expense here and there, and then pay it off right away.
What is a "good" credit score?
There is no one number that defines a "good" score. Lenders have different preferences, as you may be able to qualify for a new auto loan with a FICO score of 620, but you might need a 700 to get a conventional mortgage.
The best thing you can do to increase your credit score is to maximize each of the five categories of information that make up the FICO score, and the rest will take care of itself. If you have obstacles in your way, such as high credit card balances or missed payments in the past, it may take a little while to get there, but with some solid planning, good credit may be closer than you think.
Matthew Frankel has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.