This is How Your Credit Score is Actually Calculated

By Markets Fool.com


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When it comes to maintaining a good credit score we Americans are no better than average.

According to Fair Isaac Corp., which you might know best as FICO, the average credit score in the United States is 692. For context, FICO's credit scale ranges from a low of 300 to a high of 850. In other words, we're about as good as a "C+" when it comes to managing our payment history and that's a problem.

Why your credit score is so important
At the moment lending rates are near their historic lows meaning it could be the perfect time for consumers to take advantage of these rates to purchase a home, buy a car, or perhaps refinance an existing loan. If the average consumer is only a C+, then the average loan offer may only be mediocre.

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Lenders are looking toward consumers' credit scores to act as a guide to help them gauge how much of a risk consumers might be at repaying their loans. A better credit score is likely to result in better loan choices (i.e., more financial institutions willing to lend money and perhaps even competing over your business) as well as the potential for a lower loan rate. On the other hand, a lower credit score could land you a higher lending rate and/or fewer lending choices, or worst of all, may completely exclude you from taking out a loan altogether. In total, FICO scores are used to help creditors make about 10 billion lending decisions each year.

As we examined last month, there are quite a few ways Americans can quickly boost their credit score. But it may not do consumers any good to try and boost their credit score if they don't understand the mechanics of how it's calculated in the first place. It should be noted that FICO is somewhat secretive about how its credit score is calculated, but thanks to CreditCards.com we now have a better approximation of what matters most.

With that in mind, let's have a closer look at a breakdown of the five factors responsible for the calculation of your FICO score.

No. 1: Payment history (35%)
Should it really be a surprise that the biggest component of your credit score is whether or not you repay your loans? Your payment history acts as a roadmap for lenders to follow that gives them an indication as to whether or not you pay your bills on time.

The primary types of accounts FICO is eyeing are mortgages, student loans, car loans, and revolving accounts like credit cards. Although FICO doesn't give out specific weightings, it does note that defaulting on a larger loan such as a mortgage can do more harm to your credit score than defaulting on a revolving account like a department store credit card.

The lesson here is pretty simple: buy only what you can afford and make your payments on time.

No. 2: Credit utilization (30%)
Another important component to your credit score, other than paying your bills on time, is how you use your available credit. FICO is looking at aspects of your spending history that include how much of your available credit you're using, and whether or not you max out your credit cards. A consumer that tends to rack up big balances on their credit cards which are close to their borrowing limit may be viewed by lenders as not being able to handle their debt in a responsible manner.

What's ideal? According to FICO the utopian percentage is to use 7% of your credit utilization, although 10% to 20% is OK as well. It's worth keeping in mind that the credit utilization ratio is applied to both individual credit cards and your total borrowing capacity. In plainer terms, it means if you have one credit card maxed out and the rest with no balance your credit score could still be dinged and lenders might have a subpar view of your spending habits.

No. 3: Length of credit history (15%)
The third factor that weighs into your score, though to a far lesser degree than your payment history and credit utilization, is the length of time you've had your accounts.

Source: Flickr user _Dinkel_.

A roadmap of your credit history is only as good as the length of the road. If lenders have a long history to comb over you're liable to get a bump up in your credit score (assuming your payment history is good). Overall, FICO is looking at both the length of time your accounts have been open, as well as the most recent action on that account when tabulating your credit history length. In other words, it does no good having an account open if you haven't used it in seven years.

One key component to remember here is that older credit cards which you may not use as often anymore can still be a big benefit to your credit score. In spite of the urge to close these accounts it could be in your best interests to keep them open and use them now and then.

No. 4: New credit accounts (10%)
Consumers have to start building their credit at some point and FICO understands this. However, FICO scores also takes into account how many credit lines consumers open within a short period of time. Each hard inquiry into your credit history acts as a knock against your score, so opening multiple accounts simply for the sake of opening them can mean bad news for your score.

The suggestion offered by FICO is that you should only consider opening new accounts when it makes sense to do so. For example, chances are you won't have $250,000 in cash saved up when you buy a home, thus opting to put money down and taking out a mortgage is a financially savvy move as long as you can make your payments. However, opening a department store account to save 10% on a $12 purchase may not be the smartest move.

No. 5: Credit mix (10%)
The final component to your credit score takes into account what types of accounts you have open in your credit portfolio. FICO was less forthcoming with CreditCards.com about how credit mix is further broken down, but the basic gist is that having a mix of installment loans such as a mortgage or student loan, and revolving credit like a department store credit card, demonstrates to lenders that a consumer has a good handle on meeting their obligations.

It's a bit of a tightrope to walk, but the key takeaway with credit mix is to stay within your means, but demonstrate to lenders (when it makes sense to open new accounts) that you can handle different types of loans.

Now that you have a better understanding of what goes into your FICO score you can start 2015 off right and work toward improving your credit score.

The article This is How Your Credit Score is Actually Calculated originally appeared on Fool.com.

Sean Williamshas no material interest in any companies mentioned in this article. You can follow him on CAPS under the screen nameTMFUltraLong, track every pick he makes under the screen nameTrackUltraLong, and check him out on Twitter, where he goes by the handle@TMFUltraLong.The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter servicesfree for 30 days. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. The Motley Fool has adisclosure policy.