How does it all begin?
As you begin to develop and work with credit in your life that information accumulates as your own individual credit history. When all of the strands of your financial credit history are pulled together and compiled they become your credit report. Credit reports are maintained by the 3 major credit reporting agencies: Equifax, Transunion, and Experian (USA). Credit reporting agencies maintain people’s individual records on their use of credit and other information used to identify them. It is from the information contained within the credit report that credit scores are created. When you apply for new credit, lenders will contact one of the major credit reporting agencies and request your credit score.
The formulas used to calculate credit scores are generated by myFICO; the 3 credit reporting agencies also have their own credit score models. Your myFICO score is actually comprised of three different scores, one score for each of the different credit reporting agencies. You will notice that your three credit scores will be slightly different. This is because the various credit agencies use different models of the myFICO formula.
Understanding how your credit behaviour influences your credit standing is the first step in managing your credit situation. It is important to be knowledgeable about what a credit score means to you, what information is used to compile a credit score, and what you can do in order to improve or maintain your credit report and score.
What is a credit score? What does it mean to you?
A credit score is a 3 digit number that is an indicator of financial health and is what credit lenders use to assess how much of a credit risk someone presents. In addition to gauging credit risk, a credit score will also help credit lenders determine key pieces of information regarding the terms at which credit is lent, such as interest rates and how much credit is available to you.
While knowing your credit score is valuable, especially when applying for new credit, it is also important to understand how credit scores are calculated and why in order to help you manage and maintain your credit standing.
What is the benefit of using credit score?
What does using credit scores, as a basis for lending credit, mean to consumers? It means that credit is being lent using an unbiased, objective, and efficient system that does not discriminate based on gender, race, colour, religion, ethnicity, marital status, age, salary, occupation, employer, or employment history, etc.
Credit scores have also streamlined the credit approval process. Credit scores are easily and quickly accessible by credit reporting agencies. Since credit scores are constantly being tabulated by myFICO and other credit scoring models, credit reporting agencies always have access to the most up-to-date information. Credit scores allow for “instant credit decisions” based on “score cutoff” ranges.
Having unbiased credit scores also makes the credit lending system fairer since your credit score is calculated using only pertinent financial information and not personal information.
Credit scores also make older credit problems count for less. Therefore it is possible to improve your credit situation regardless of past mistakes. The impact of particular occurrences matter less as time goes on and as recent positive credit behaviour is reported.
How are credit scores calculated?
Credit scores are calculated using 5 specific financial categories from credit profiles: payment history, amounts owed, length of credit history, new credit, and types of credit in use. Your credit score is unique to your own credit situation and therefore the weight of each category will vary from person to person. Credit scores are not determined by one or two categories alone; they are the combined total of all aspects of your credit history. Therefore, the significance of any one category is dependent on the sum of all information kept within your credit report.
Although your own, individual, credit score is unique to you, there is a general break down of the weights of each of the 5 categories based on the importance to the general population.
Payment history is one of the first pieces of information that lenders will want to know about your credit history. Payment history will generally account for roughly 35% of the information used in calculating a credit score.
Payment history is the “log book” of all payment activity associated with your credit history. It registers whether payments have been made on time or not and the types of accounts associated with those payments. Types of accounts monitored are credit card accounts, retail accounts, installment loans, finance company accounts and mortgage loans.
While making on-time payments is important it will not singlehandedly determine your credit score. Having a well rounded good credit picture will be more influential than one or two late payment records. However, if late payments are consistently reported on your credit profile, it will adversely affect your credit score.
In addition to monitoring payments made, or not made, payment history also takes into account any collections (any attempt to recover over-due credit obligations by a collection department or agency), delinquencies (failure to deliver even the minimum payment on a loan or debt payment on or before the time agreed. Accounts are often referred to as 30, 60, 90, 120 days delinquent because most lenders have monthly payment cycles), or adverse public records (any bankruptcies, tax liens, judgements, suits, and wage attachments) that you may have incurred. These types of payment records are considered to be serious and will adversely affect your credit standing.
The details on missed or late payments, adverse public records, and collection items are also recorded and they will influence the severity of the offence. Your credit score will consider how late they were, how much was owed, how recently they occurred, and how many there are. More recent offences will count more than past offences and how far past the due date a payment was (30, 60, 90, or 120 days late) will be more significant. So, older items with smaller amounts owed will be less significant that newer items with larger amounts owed.
All this considered, it is important to the performance of your score to pay your bills consistently on time. Having a good track record of positive payment on your credit profile will significantly benefit your credit score. Missing a payment won’t destroy your credit score, but it is important to stay up-to-date with all payments.
Amounts Owed / Outstanding Debt
Recall that a credit score is a number that indicates to credit lenders how risky of an investment someone is. Another way of saying this is: how much doubt do credit lenders have that a particular person will pay back their credit within the set of agreed upon terms. This doubt is based on your credit score. The lower your score the more doubt there is about your ability to pay back the credit that was extended to you. Therefore, credit lenders often look at how much you currently owe as a way of deciding if your level of risk is acceptable to them. Amounts owed generally accounts for 30% of the financial information used to establish your credit rating.
Amounts owed takes into account the total dollar amount owed on all types of accounts. Any credit account balances will appear on your credit report. In addition to recording the overall amounts owed, what you owe on specific types of accounts is also logged.
Credit lenders also consider how many of the total credit accounts are running a balance. Having numerous credit sources with balances can signal to credit lenders that there could be a risk of over-extension.
Credit scoring formulas also take into account how much of the total credit line is being used on revolving credit accounts. Constantly running high revolving credit limits increases doubt in your ability to pay down the balance and increases concern if you will be able to make payments on time. There are different opinions on where account balances should be kept in relation to your credit limits. Transunion suggests that account balances should be kept under 30% of your available credit limits; credit balances that run above 50% of the total amount of credit available can adversely affect your credit score. Equifax, however, suggests that credit balances should be kept below 75% of the total available credit. Like all of the factors that influence a credit score their influence will depend upon your own unique credit profile so these percentages are not set in stone. Demonstrating that you are able to manage how high your credit balances run will indicate to credit lenders that you are managing credit responsibly and will be better for your credit score overall.
If you have installment loans, your credit score will also consider how far you have come in paying down the principal amount of the loan. Paying down installment loans positively affects your credit score because it demonstrates that you are willing and able to manage and repay your debt according to the terms of your loan agreement.
It is impossible to generalize which of these factors has more influence on how good overall your amounts owed section of your credit profile is but there are a few things to keep in mind for making a healthy credit score:
Manage your credit limits responsibly. Make your existing credit accounts look as appealing as possible to credit lenders by minimizing how risky you look financially. Wracking up revolving credit limits shows signs of possible instability but so does having large amounts of credit accounts. Second, pay off your debts and do not move around them. Third, open only the credit accounts necessary. Having numerous credit accounts, while increasing the amount of credit available to you, could hurt end up hurting your credit score in the long run. Be aware of your financial credit limits and stay within them.
Length of Credit History
Length of credit is basically how long you have been establishing credit. It accounts for approximately 10% of the material used to calculate your credit score. Having a longer credit history, aka more information in your credit report, will be better for your credit score (depending of course on the rest of the information contained in your credit report) because it gives credit lenders more information to use to assess risk.
Length of credit history is determined by looking at how long you have had credit accounts. This looks at the age of your oldest accounts, the newest, and the average age of all your accounts. Length of credit history will also account for the age of specific accounts and how long since certain types of credit accounts were active.
There is no quick fix to developing your credit history, it is a matter of time. Opening numerous credit accounts in a short period of time will not increase the length of your credit history and it could actually negatively affect your credit score because it lowers your average account age.
New Credit / Recent Inquiries
New credit looks at if you are taking on more debt. Roughly 10% of your credit score is based on this information. It is a reality that more people use credit today. As more credit becomes available people tend to “shop around” more for the best terms. Your credit score will take into account how many new accounts you have opened and how many of your total accounts are new.
Applying for new credit causes hard inquiries (an item on a consumer’s credit report that shows that someone with a “permissible” purpose has previously requested a copy of the consumer’s report) to be made into your credit file. Your credit score takes into account how many inquiries have been made into your credit file and the time since the inquiry was made. Numerous credit requests (inquiries) represent greater risk to credit lenders as such they will negatively affect your credit score. That being stated, credit score formulators, like myFICO, recognize the difference between multiple inquiries and when people are shopping around for the best credit options available. When shopping around for the best credit options available to you make sure to keep all inquiries within a certain period of time, 30 days is the most common citation.
Additionally, your credit score will recognize whether you have good recent credit history, following past payment problems. Positive payment behaviour is the best way to help raise your credit score.
Types of Credit in Use
Your credit score will also take into account the general mix of the credit accounts under your name. What the best mix will depend entirely upon your own, individual, credit history. There is no perfect combination of accounts that will boost your credit score. The mix of your accounts account for approximately 10% of your credit score.
The credit score formula will consider what types of accounts you have, whether they are all one type of accounts (revolving credit, installment loans, finance company accounts, retail accounts, etc.) or a mix of different types. This does not necessarily mean that diversity in account types is a sure-fire way to guarantee a good credit score, it is just one of many factors that your credit score will take into account. In addition to the general mix of accounts you have, the number of each type is also accounted for. There is no cut off number for what is a good or bad amount of one particular type of credit account the impact will depend entirely upon your own credit profile.
Remember that types of credit in use only amounts to 10% of the total information used in calculating your credit score; therefore, it’s better to have one type of credit and good payment history as opposed to numerous types of credit and poor payment history.
How to manage your credit profile?
While it is very important to take the necessary steps to manage your financial credit history in order to make your credit score as good as possible it is also crucial to monitor the information within your credit report. Inaccuracies can be just as detrimental to your credit score as a poor payment history or having large amounts of money owing on credit accounts. There are a few things you can do in order to ensure your credit report is as accurate as possible.
First and foremost, it is crucial to review your credit report periodically for inaccuracies. Check to make sure that all of your contact information is correct and identifies you; only your financial history should affect your credit, not someone else’s. it is easier to fix incorrect information, errors in credit records, inaccuracies in payment history, and to prevent unauthorized hard inquiries as soon as they occur. Do not be afraid to check into your credit profile; personal inquiries do not affect your credit score and do not appear on your credit report that credit lenders request.
Be aware of your credit profile. Identifying inaccuracies will keep your profile healthier overall and being familiar with your credit report will allow you to identify possible areas of concern. For instance, knowing that you have a history of late or missed payments will better prepare you to take positive action.
Second, if you notice an error in your credit profile, do not wait to contact your creditors or send letters of dispute to the credit reporting agency to have the errors on your credit profile corrected. Errors may take some time to be corrected depending on the severity so allocate enough time for the error to be resolved before you need to apply for new credit.
Third, be sure to follow up. Check back with your credit within 30-60 days after reporting errors to ensure that the inaccuracy has indeed been corrected. If disputed errors remain you will have to further your dispute. Be sure to keep records and copies of all documentation regarding the dispute. It can even be beneficial to keep old credit profiles.