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How is Your Credit Score Calculated?
Published by Jacob McCoy, Credit Investment Analyst for eQcho
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If I told you there was a non-arbitrary, highly complex score that defines your historical financial life, but will also continue to influence your future financial life, wouldn’t you want to know what that score was and optimize it? From applying for a credit card, to qualifying for a mortgage, this score will be one of the most influential factors that determines the terms associated with the terms you can get. This score is your credit score.
Do you have any idea how it’s calculated? No? You’re not alone. The inner workings of the credit scoring system are closely guarded secrets, which is truly absurd. Nonetheless, I’ll attempt to breakdown what we know and what you can do today to influence your credit score in the positive direction.
Firstly, it’s important to understand there are three credit reporting agencies, ie companies that catalog and sell your information regarding your payment history. These three companies are:
Let’s say you apply for an auto loan. A credit report will be generated and it’s likely that all three companies will report a “credit score” to the credit report. These scores will range from 300-850, with low being poor and high being considered excellent. These credit scores will then determine the rate and terms of your auto loan.
Now, let’s improve your credit score so you can get the best rate and terms. Although not set in stone, your credit score is estimated to be determined by five factors.
The first and third factor, ie payment history and length of credit history, will have the largest influence on your credit score. Banks like to see a longer record of on-time payment history, because they believe a long past record of on-time payments will likely lead to a future of on-time payments. This makes sense when you think about it and is why a young person looking to get an auto loan will likely have to have a co-signor. Knowing this, you should look to keep credit accounts open for as long as possible, and keep them up to date. A successful mortgage payment history is great for a credit score.
Credit utilization is trickier than length and payment history, and is likely the second largest influence on your credit score. Credit utilization is basically your use of your available credit. For example, if you have a credit card with a limit of $5,000 and an auto loan for $5,000, your total available credit is $10,000. Let’s also say the balance on your credit card is $1,000. This means your credit utilization is ($1,000 + $5,000) ¸ $10,000 = 60%. This would be considered “high” and may negatively impact your credit score. It’s estimated utilizing 30% of your total available credit is the sweet spot.
The fourth factor, ie how many new credit inquiries have been had in the last 12 months, has much less of an impact on your credit score. However, this one is interesting because notice the word “inquiry.” Even if you apply for an auto loan, but get declined, or apply for a credit card and get declined; these will negatively impact your credit score. So, it’s important to be sure you want to apply for whatever kind of credit you’re applying for.
Lastly, your credit mix. Your credit mix is defined as the different types of debt you have against your name. Different types of credit include credit cards, auto loans, mortgages, home-equity lines-of-credit and even a store-brand credit card. You optimize this factor by holding several different types of credit in your name. You might think it to be the opposite, but basically holding different types of credit creates a larger history for which the credit reporting agencies can gather from.
Knowing what you know now, I only hope you can start negotiating the terms of your next auto loan instead of just being told “this is what you get, deal with it.” It’s extremely far fetched that there is this score called a credit score and is tracked behind the scenes; and it only comes to light when it’s going to work against you. Start making it work for you, not against you.