Credit scores are crucial in today’s financial world. They help lenders decide whether to give you a loan and what interest rate to offer, and they can even affect things like renting an apartment or getting a job.
But how exactly is a credit score calculated? How many factors are taken into account when calculating a credit score? Let’s break it down in simple terms.
Understanding Credit Scores
Before diving into the factors, let’s understand what a credit score is. A credit score is a three-digit number that indicates how trustworthy you are with credit. It ranges from 300 to 850, with higher numbers representing better credit.
How Many Factors Are Taken Into Account When Calculating A Credit Score?
There are five primary factors that credit bureaus consider when calculating your credit score. Each of these factors has a different level of impact on your overall score. Let’s explore each one:
1. Payment History (35%)
Payment history is the most important factor in your credit score. It shows whether you have paid your past credit accounts on time. This includes credit card payments, loans, and other types of credit.
Why It Matters
- Lenders want to see that you have a history of paying your bills on time.
- Late payments, defaults, or bankruptcies can significantly lower your score.
Example
If you have a credit card and always pay your bills on or before the due date, this positively impacts your payment history. On the other hand, if you miss payments or are late frequently, it will hurt your score.
2. Amounts Owed (30%)
This factor looks at how much debt you have and your credit utilization ratio, which is how much credit you’re using compared to your credit limit.
Why It Matters
- Lenders want to see how much debt you currently have and if you are managing it well.
- High credit utilization (using a large part of your available credit) can indicate you rely too much on credit and might have trouble paying it back.
Example
If you have a credit card with a $1,000 limit and you’re using $200, your credit utilization ratio is 20%. Keeping this ratio below 30% is generally good for your score.
3. Length of Credit History (15%)
This factor looks at how long your credit accounts have been open. It includes how old your oldest account is, how old your newest account is, and the average age of all your accounts.
Why It Matters
- A longer credit history gives lenders more information to assess your creditworthiness.
- Having older accounts typically helps your score, as it shows a longer track record of credit management.
Example
If you opened your first credit card five years ago and another one three years ago, your credit history length is influenced by both accounts. Keeping old accounts open can benefit your score.
4. Credit Mix (10%)
Credit mix pertains to the different types of credit accounts you hold, such as credit cards, installment loans (like auto loans), and mortgages.
Why It Matters
- Lenders assess your ability to manage various forms of credit responsibly, which indicates your overall creditworthiness.
- Having a diverse range of credit types can enhance your credit score, although it’s not mandatory to possess every type of credit.
Example
If you possess a credit card, an auto loan, and a mortgage, you exhibit a well-rounded credit mix, positively impacting your score. However, if you only have credit cards, it doesn’t severely disadvantaged your score, though a mix is preferable.
5. New Credit (10%)
This component evaluates the number of new credit accounts you have recently opened and the frequency of recent credit inquiries. Each time you apply for new credit, it triggers a hard inquiry, which can temporarily decrease your credit score.
Understanding and managing these factors can significantly influence your overall credit profile and financial health.
Why It Matters
- Opening many new accounts in a short period can be seen as a sign of financial trouble.
- Hard inquiries can slightly lower your score, but they only impact your score for a short time.
Example
If you apply for several credit cards within a few months, it can negatively impact your score. However, if you only apply occasionally, it won’t have a significant effect.
Also read: What is One of the Best Ways to Get Reliable Information About a Product?
Additional Considerations That Affects Your Credit Score
While the five main factors cover most of what affects your credit score, there are a few other considerations and tips to keep in mind.
Soft Inquiries vs. Hard Inquiries
- Soft Inquiries: These are checks made by lenders to pre-approve you for offers or by you checking your own credit score. They do not affect your score.
- Hard Inquiries: These are checks made when you apply for new credit. They can slightly lower your score.
Public Records
- Bankruptcies, home seizures, and tax debts can really hurt your credit score and stick around on your credit report for a long time.
Tips for Maintaining a Good Credit Score
To keep your credit score healthy, make sure you manage your credit responsibly.
Here are some practical tips:
- Pay Bills on Time: Always pay at least the minimum amount due on your credit accounts before the due date.
- Keep Balances Low: Try to keep your credit utilization ratio below 30%.
- Don’t Close Old Accounts: Keeping older accounts open can help maintain a longer credit history.
- Limit New Credit Applications: Avoid applying for multiple new credit accounts within a short period.
- Make sure to look at your credit report often: Check it for mistakes and tell them if something’s not right.
Example Scenario
Let’s look at an example to understand how these factors come together.
Scenario
Maria has a credit card, a car loan, and a mortgage. She always pays her bills on time, but she recently maxed out her credit card. Here’s how each factor affects her score:
- Payment History: Positive impact because she pays on time.
- Amounts Owed: Negative impact due to high credit utilization on her credit card.
- Length of Credit History: Positive impact as she has had her accounts for several years.
- Credit Mix: Positive impact because she has a mix of credit types.
- New Credit: Neutral, as she hasn’t applied for new credit recently.
Despite her positive payment history and diverse credit mix, her high credit card balance could lower her score. To improve it, she should pay down her credit card debt to reduce her credit utilization ratio.
Conclusion
Understanding how many factors are taken into account when calculating a credit score can help you make informed decisions about managing your credit.
Remember the five key factors: payment history, debt amounts, credit history length, credit mix, and new credit.
By focusing on these and practicing good credit habits, you can keep or improve your credit score, helping you reach your financial goals.