how credit scores are formulated
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If you’ve ever been in the market for new credit, then you’ve probably developed a healthy interest in your credit scores. After all, these numbers are the keys to whatever dream of yours that credit will buy. But knowing your scores is one thing — what about knowing the ways you affect your scores? In order to do that, you must first find out what goes into them. Here’s what you should know about how credit scores are formulated.

How Credit Scores Are Formulated

Before getting into the factors that determine your credit scores, it’s important to know that there are two major credit scoring companies: FICO® and VantageScore®. Each of them has their own credit score models — and each has many models at that.

In short, we all have a multitude of credit scores that can vary. That said, here are the five basic components that are considered in formulating credit scores.

Payment History

First and most important is payment history. Whether or not you make your payments on time on all of your debt accounts and other bills will largely determine your credit score. That’s because lenders looking at a credit application mostly want to understand if you’ll pay the debt back as promised. Seeing late payments on other accounts might make them think you won’t.

As long as you’re not living paycheck-to-paycheck or taking on more debt than you can handle, then this is one of the easiest ways to build and maintain good credit. By simply paying all of your debt bills in full and on time every month, you’re working to build good credit. (Rent and utility bills aren’t currently factored into your credit scores unless they’re paid late, but that could change soon.)

If you’ve developed a history of late payments, then your credit scores have likely already taken a hit. That said, the impact of these late payments on your credit will go down over time. As long as you pay on time moving forward, you have a chance to turn the ship around.

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Amount of Debt

The other thing lenders want to know about you as a credit applicant is how indebted you already are. If it appears you’re stretched too thin, lenders might think twice before lending to you — or it could mean they’ll approve you for credit at a higher interest rate.

The reason goes hand-in-hand with the reason stated above. A lender wants to know not just that you intend to pay your bills on time and in full, but also that you actually can and will do so. Good intentions are one thing, but if you appear to have too much debt, they won’t matter for much.

So, what’s the magic debt number? It’s actually a percentage called the credit utilization ratio (sometimes also referred to as the debt-to-credit ratio). Many experts recommend a credit utilization of 30 percent or less. What that means is you don’t want your balances on revolving debt to exceed 30 percent of the amount of credit available to you. In other words:

  • Add up the credit limits on all of your credit lines (such as a credit card or line of credit).
  • Add up all of the balances on your credit lines.
  • Divide your balances by your credit limits and multiply that by 100 — the number you get is the percentage of your credit utilization.

Note that the experts don’t say to maintain a balance on your revolving credit lines. The lower your credit utilization, the better, with zero being the best. It’s a common credit myth that you need to carry a balance over from month to month, but you don’t. All you have to do is use credit to build credit; you don’t need to go into debt for it.

Length of Credit History

Another factor used to formulate your credit score is length of credit history, also an easy one to maintain. The older your accounts, the longer your credit history, the more you can show years of experience managing credit.

There is a practice that could inadvertently hurt you in this area though: closing old accounts. If the accounts you’re closing show positive payment histories and credit usage, closing them only hurts your credit scores.

This might happen most often with credit cards, as it’s tempting to close the ones you stopped using. The thing is, the lack of use can already cause the credit card company to close the account themselves. If you want to prevent that, you could use the card periodically for small purchases, paying it off before the end of the month so you can avoid interest charges. That’ll help you keep the accounts that can help your length of credit history open.

A loan with a fixed payment period (like an auto loan or mortgage), on the other hand, will automatically close when it’s paid off. However, all accounts stay on your credit reports for a number of years (varying per debt type), so you can still potentially benefit from those as well.

New Credit

New credit is a tricky credit score factor. A lender doesn’t want to see a credit history full of recent credit inquiries, as that could look like desperation. The idea is that someone who’s desperate for new credit might be financially overextended, and thus unlikely to be able to repay new debt.

That said, this factor is not as important as the three above, and there are times when it makes sense to apply for multiple loans at once. One time is when you’re in the market for a new house or a new car and you want to see which lender will give you the best interest rate. You can look around for the best interest rate on these types of loans without hurting this aspect of your scores by doing the following:

  • When you apply for multiple loans, only apply for one type of loan. (In other words, don’t shop around for a mortgage while shopping around for a new auto loan.)
  • Each loan you apply for should be for the same amount. This is easier to do if you decide on a budget for the item you’re purchasing before you shop for loans. Then stick to that amount on all of your applications.
  • Keep your applications within a small window of time — more specifically, within 14-45 days. According to myFICO, FICO® Scores look on your credit report for inquiries older than 30 days. If some are found, your scores will typically consider them as rate-shopping and present them as just one inquiry. So to be extra safe, try to apply for credit within 30 days.

These three things together signal to lenders that you’re rate shopping and thus ensure that each new credit application doesn’t cause another hit on your credit score. That’s because the behaviors above, when done together, show that you’re not planning on taking all the loans you’re applying for, but merely applying for several to then choose the best one.

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Credit Mix

Finally, we have credit mix, or the different types of credit that appear on your credit reports. It can help your credit scores to have more than one type of credit, such as a student loan and a credit card or an auto loan and a mortgage, since that shows you can handle multiple types of credit.

That said, this is a very small factor in how your credit scores are formulated, and it’s likely not worth going into unnecessary debt just to improve your credit mix.

Keep Responsible Credit Usage Top of Mind

Since credit scores are important factors when it comes to approval for new credit and the interest rate you’ll get, then you’ll want to get the highest credit scores you can. Although that’s a perfectly reasonable goal, there’s no reason to stress out over it.

If you look into how credit scores are formulated, you can probably see a pattern: Lenders want to work with consumers who’ll honor their end of the bargain. Credit scores were formulated to help lenders understand how likely we are to do that. That’s why so many of the factors listed above boil down to the likelihood that a borrower can and will repay the debt.

Therefore, if you take nothing else away from this article, let it be this: You can build and maintain good credit by only taking on debt that you can handle, paying all of your bills on time, and paying down any large amounts of revolving debt you’re carrying. These actions aren’t just good for your credit scores — they’re good for your finances as well.

Get more key facts about credit scores and credit reports here