What Is a Credit Score

A credit score is a numerical expression based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person. Credit worthiness is typically defined as the likelihood that an individual is going to pay their accounts, preferably on time. So lower your score, the more risk you pose to a lender, the more likely you are going to get a less favorable interest rate on a loan.

A credit score is primarily based on credit report information, sourced from credit bureaus (Experian, Transunion, and Equifax). While there are different ways of calculating a credit score, the most widely accepted method was developed by the Fair Isaac Corporation. If you plan on buying a home, you should be most interested in the FICO score. The three major credit bureaus also have their own scoring model that they have developed which are called Score Power, Plus Score, and Vantage Score. Since the bureaus have their own scoring model, your credit score varies somewhat across all three bureaus. They also tend to differ on what information they have on your report. For example, an error might show up on two reports but not the third. If a mortgage broker chooses to view these scores, they will always choose to base your rate on the middle of the three scores.

Did you know that as an American citizen, you are entitled to a free annual credit report by law?

The three credit bureaus run a website called www.annualcreditreport.com where you can obtain the report but not your score. This allows you access to your financial identity that lenders use to set interest rates. This free access to your report is not based on a FICO score.

Not buying a home? Your credit score follows you to other places too!

Your credit score is used in some of the most unlikely places. Your score is not just used for credit cards, auto loans, and home mortgages. If you want a mobile phone, good insurance rates and even a job, it would benefit you greatly to have a favorable credit score.

Credit Score Breakdown:

  1. Payment History (35%)
  2. Amounts Owed (30%)
  3. Length of Credit History (15%)
  4. New Credit (10%)
  5. Types of Credit Used (10%)

35 percent of the score is based on your payment history. This makes sense since one of the primary reasons a lender wants to see the score is to find out if (and how promptly) you pay your bills. The score is affected by how many accounts have been paid late, how many were sent out for collection and any bankruptcies. When this activity occurs also comes into play when defining credit history. The more recent the negative activity, the worse it will be for your overall score.

A great way to establish good credit history going forward is to setup autopay or automatic withdraw. Most places that bill you offer services that will automatically pull the amount due from a credit card or bank account. Just remember that if you use a credit card for autopay that you also setup autopay on your credit card account too to make sure that nothing is being paid late.

30 percent of the score is based on outstanding debt. If you currently own a home, car, and have credit cards, you most likely have some debt. Never max out credit cards or leave them open with no activity. The rule of thumb is to keep your card balances at 25 percent or less of their limits. A great way to see immediate raises in your credit score is to take care of credit cards first. Choose to pay down the credit card with the highest interest rate or the cards that you are late on payments. Another great financial tactic is to pay one extra house payment a year to your lender. On a typical 30 year loan, you will shave 8 years off the total and end up paying your home off in 22 rather than 30.

15 percent of the score is based on the length of time you've had credit. If you've just graduated from college, you most likely have a short credit history and are more risky to loan money. The longer you have established credit, the more likely a lender will loan you the money you need. This is based on open accounts and your credit score will not be able to take in account for anything that has been closed. Just remember that while you may have a longer credit history, if that history was full of negative things like late payments and collections it won't matter how long of a credit history you have.

10 percent of the score is based on new credit. Typically your score will go down for awhile after you have opened up a new line of credit. The major factor of this percentage comes from inquiries. There are two types of inquiries; soft and hard. A soft inquiry does not affect the credit score and usually involves a quick glance at your score. A hard inquiry does lower your credit score and typically is a result of actions initiated by you in an effort to obtain credit. If you open 2 new credit card accounts, take out a private bank loan, and attempt to buy a new car, your score will go down...the good thing is that your score will rebound from these inquiries.

10 percent of the score is based on the types of credit you currently have. This category consists of 4 types of accounts:

  1. Revolving (credit cards, lines of credit, HELOC)
  2. Loans
  3. Public Records (bankruptcy, liens)
  4. Collections

Some types of accounts can really help you score as long as you are paying them on time such as a student loan, car loan, mortgage, and credit cards. If you have ever had a public records such as a bankruptcy, tax lien, or a collection, your credit score is going to be negatively affected. Beware of companies that claim that they can remove a bankruptcy or a collection off your credit report. These items will eventually not be detrimental to your credit score so time often is the best answer for dealing with these actions in your credit history.

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