They may be three simple digits but your credit score is the probably most important number in determining your financial future.
Your credit score is both a representation of your payment history and a prediction of your ability to make future payments. Every time you apply for a loan, use a credit card, miss a payment, or go over your credit limit, that particular action is factored into a formula that generates your credit score. Lenders use this credit score to help determine how likely you are to pay a loan when it is due. It is their way of predicting the risk a lender will be taking when giving you a loan. The higher your score, the lower your perceived risk of default, and hence, the lower your interest rate.
The most common use of a credit score is to determine the interest rate you will receive on your loans. However, insurance companies, landlords and potential employers may also use the score to make decisions that can affect your life.
For a number that is so important to your financial well being, credit scoring is a bit of a mystery to most consumers. It is difficult to predict with complete certainty exactly what your score will be and how you can change it. Adding to the confusion, the credit score you purchase from a credit reporting agency may be very different from the score your lender sees. Lender's scoring models place nearly one in five consumers in different credit categories, according to a new report by the Consumer Financial Protection Bureau. This means consumers can't exclusively rely on the credit score they purchase from credit agencies to be an accurate indicator of the interest rate on the loan they will receive.
There are two types of credit scores: FICO and VantageScore. FICO, created by Fair Isaac, is the oldest and most commonly used score. It has a range of 300-850. VantageScore was created five years ago by the three major credit bureaus--Equifax, TransUnion and Experian--to compete with FICO. The Vantage Score scoring range is 500-990.
FICO Scoring Formula
- Payment history. 35 percent of the total credit score is based on your payment history. This means that repaying your debt on time is the most important factor in your credit score. Lenders use past-payment behavior to forecast future long-term behavior. This includes credit card, auto and student loans as well as mortgages. Improve this section of your score by paying on time, every time. Late payment behavior can be overcome, and making payments on time will raise a FICO score over time.
- Debt amounts. 30 percent of the total credit score is based on your total outstanding debt. Credit cards and other revolving lines of credit are more heavily weighted. It is a good idea to stay below 30% of your credit limit. Maxing out credit cards or maintaining a balance close to the credit limit are signs that you cannot pay for the debt you already have. Improve this section of your score by paying more than your minimum payment each month, and paying off your debt as quickly as possible. If you pay off your credit card, you can stop using the card, but don't cancel it. The available credit line on that card will boost your debt utilization score.
- Length of credit history. 15 percent of the credit score is based on the length of time each account has been open as well as the length of time since the account's most recent action. This part of the score takes years to build, and it gives lenders a better understanding of your lifetime of financial behavior. If you are starting out, finding a good credit card and sticking with it is a good way to begin building credit history.
- New Credit. 10 percent of your credit score. Opening several new credit accounts in a short period of time represents greater risk, especially for people who don't have a long credit history. If you are just starting out, don't apply for a number of new accounts too quickly. New accounts will lower your average account age, especially if you don't have a lot of other credit information.
- Credit Mix. 10 percent of your credit score. This considers your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. Credit mix shows you can handle a variety of credit. However, you don't need all forms of credit. Don't open credit accounts you don't need. Credit mix is more important if your credit report does not have a lot of other information on which to base a score.
FICO says that the importance of these categories may vary by one individual to another. For example, people who have not been using credit for a long period of time will be scored differently than those with a longer credit history.
VantageScore Scoring Formula
VantageScore uses a number of the same factors but assigns different levels of importance to them. The formula is made up of six factors: recent credit (30 percent), payment history (28 percent), debt utilization (23 percent), balances (9 percent), depth of credit (9 percent) and available credit (1 percent).