Most people don’t know how the credit bureaus (Equifax, TransUnion, and Experian) credit score is calculated. They get a general idea, of course: pay your bills on time and in full, and you will have a great score. Do the opposite, and your credit will suffer. But when it comes to the details, many people look at credit scoring as something with a lot of mystery.
The credit scoring bureaus take five things into account:
1) Your payment history: 35 percent of your total score hinges on your bill-paying record. If you are late on your loan repayment, your lender is likely to pass that information onto a bureau. When they do, it will stay on your record for as long as seven years. Of course, the significance of a missed payment fades over time. The bureaus know that your recent behavior says more about the state of your finances.
The bureaus look at all kinds of loans: installment loans, credit cards, student loans, car loans, mortgages, and others. Size matters. If you default on your mortgage, that will hurt you more than never paying down on your credit card balance.
2) Credit utilization: 30 percent. If you only take out a fraction of your credit limit, then your score will improve. Credit utilization determines 30 percent of your overall score. Most people know that if you have paid off all of your debt, your score will improve. But fewer know that the bureaus tend to give you some breathing room. If you can manage to never owe more than 30 percent of your outstanding credit limit, you will pass their muster. The bureaus are mostly trusting the lenders that you are a safe risk, based on the idea that they wouldn’t let you have a large line of credit if you were not a safe bet for repayment. But this factor only matters for revolving loans (credit cards, lines of credit) where you can take out more or less credit over time.
So far, we have shown that two factors make up almost 2/3rds of your overall credit score. You should take that to mean that as long as you pay your bill on time and don’t run up a huge balance, you will probably have a good score.
3) The length of your credit history: 15 percent. How long has it been since you started borrowing? Have you had an account open for a long time, and if so, how many years has it been? Keeping a credit account in good standing for a long time says that you have a stable financial life. The upshot: don’t close a credit account just because you no longer need it. Keep it open and maintain the balance at zero.
4) The number of accounts that you have recently applied for: 10 percent. It worries the credit bureaus when you suddenly start to apply for all kinds of different credit accounts. It triggers a flag that says that you may be in financial trouble. They notice every time you ask for credit. Note: this is not the same as when a company asked to review your credit as a condition of evaluating you for something other than a loan. If for example, you apply for a job and the employer decides to check your credit, your credit history will not be impacted.
5) The types of credit that you currently have: 10 percent. How the credit bureaus think about you depends on what kind of loans you have. If you have a mortgage, then they may think better of you than if you have several high-cost installment loans. They also like it when you have taken out a variety of loan types. Having a mix of credit cards, installment loans, and fixed loans tells them that you understand the terms of your loan.