How Are Credit Scores Calculated?

Your credit score, also called a Fair Isaac (FICO) can be generated for anyone with at least one credit trade line reported and updated within the last 12 months.

The actual formula for calculating a FICO score is proprietary, but there are some general guidelines and rules that we know about how to improve, and what will hurt, you credit score.

Fair Isaac’s scores are relied upon by investment markets and banks are based on comparing millions of credit reports with past history to predict repayment risk to a new creditor.

Credit Score “Snapshot”

Your credit score is generated at the precise time the creditor or lender requests the credit report.  This means that your credit score can change depending on what day of the month your credit is pulled.

Credit scores are a fluid as the underlying data.  If you have 3 credit cards from different companies, they may not “report” your last received payment on the same date.

Credit Categories that Impact Score

Only the information that is reported to the credit bureaus is used to determine your credit score.  If a creditor does not report to the bureau, it will not impact the score.

This percentage chart simplifies the relative importance of each category to the FICO score

35% – Payment History is the most important factor in determining your credit score.  On-time payments are expected.  Late payments, collections, bankruptcies or tax liens will have the biggest negative impact on your score.

30% – Amounts Owed is the second most important factor in determining your credit score.  This is also greatest opportunity for making quick improvements to your credit score.

Credit card balances above 30% of the high credit limit will have a significant negative impact on your score.  Paying these balances down or off will give you an immediate boost in borderline scores.

15% – Length of Credit History plays a smaller but still significant role in your credit score.  The longer your history, especially with a particular credit line, like a credit card, the better this weighs in on your positive rating.

10% – New Credit will most commonly show an increase in risk as it extends your ability to go into debt.  If you recently add a credit card with a $5,000 credit limit, this shows a new creditor that you do not have that money saved, and you needed to borrow that money to meet financial needs.

A new creditor has to assume that you will borrow the full amount at any time, reducing the money available to pay new expenses.

10% – Types of Credit Used also plays a minor, but important role in calculating your credit score.  Inquiries and applications for new credit are calculated as the potential to increase risk and may result in temporarily reduced scores.

Installment vs Revolving Debt

Installment debt such as student loans, auto loans and mortgage loans primarily impact the payment history reporting part of your credit score.  Amounts owed is set at a fixed amount and does not have the ability to increase, causing the payments to fluctuate.

Including a mortgage in bankruptcy will often result in the lender ceasing to report the payments to the credit bureaus.  A common misunderstanding is that this hurts your credit, which is not true.  Your credit score in this instance is only being impacted by the bankruptcy and will be recover over time.

Revolving Debt has a far greater impact on your credit score.  At any time, you have the ability to max out credit cards to high credit limits, incurring higher monthly liability and causing a higher risk of late payments or default.

A sudden increase in credit card charges is usually a sign that a borrower does not have money saved for emergencies or necessary purchases and, if not paid off or down (to under 30% high credit limit) within the next billing period, can negatively impact your credit score.

Best Practices for Building Good Credit

Most “bad credit” that I see as a mortgage lender comes from folks not knowing how to build good credit.

Improving your credit scores is not that difficult – here are a few best practices I’ve used over the years:

  • Have at least 3 revolving (credit cards) credit lines in good standing.
  • Use all 3 cards at least once, paying them down to a $0.00 (zero) balance on the first billing cycle.
  • Use only 1 of the above mentioned cards for convenience –  leave the other two at home in a drawer or somewhere safe.
  • Pay off balance every month.  Not only does this allow you to avoid interest charges, keeping your balance low builds good credit.

Following these very simple rules will go a long way to putting you a position to use your good credit scores for important purchases like a home mortgage loan.

If you are trying to apply for a home mortgage and are unsure about your credit, or know you need to improve your scores to qualify, a mortgage lender has access to credit tools that might speed up the qualifying process.

There are many tools and services that we have access to that can analyze and suggest ways to improve your scores to within qualifying limits.

Have questions about credit?  Feel free to give us a call, shoot me an email, or ask a question below so that others may also benefit from answer to common questions about building good credit.

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