Calculating Your Credit Score: Why does it matter?

Any business that relies on consumer lending (ie. banks, car dealers, mortgage brokers, etc.) need credit scores. Using them allows them to quickly decide if you are worthy of credit and if so, what your interest rate will be. Using credit scores is a quick and easy way for lenders to keep up their volume of lending. Credit scores allow lenders to decide immediately whether they can sell you a car or give you a credit card right away.

Consumers can improve their credit scores by planning their credit use to bolster their standing in the eyes of the credit agencies. To do this, knowing how the scores are calculated is extremely important. Here is what you need to know.

How credit scores are calculated

A company called Fair Isaac created the credit scoring system that is in widespread use today.  They keep the exact formula private but due to pressure from consumer groups and the government, they have given us a general framework of how their system works.  This information gives people who want to improve their credit score a leg up. By knowing what goes into the formula, consumers are able to make decisions with their money in ways that can improve their credit scores.

Credit Scores are composed of someone’s history of payments, current debt outstanding, how long your credit has been established, the number of new credit accounts, and types of credit accounts. Each of these different factors comprise a percentage in the formula used to calculate your credit score. Your credit history makes up 35 percent of the score’s calculation.

35% of you score depends on your payment history and whether your bills are paid on time. The formula takes off points for late payments, accounts you have had sent to collection agencies, and any bankruptcies you had in the past 10 years. When accounts you have that are in collections are satisfied, some of the point deduction falls off. This is also the case with accounts that are late. The longer a bankruptcy occurred in the past, the less it affects the score.

Outstanding debt makes up 30% of the score. It is almost as important as your payment history. While it may appear that payment history is vastly more important than your outstanding debt, in terms of credit risk, the two are very close in significance. Even if a person has a good payment history, a significant amount of outstanding debt indicates that person has fallen into a debt situation that has the potential to become unmanageable.

Length of credit history also plays an important role in your credit score. In this category, people who are older or established credit at a younger age have a major advantage. The formula uses length of credit history as the basis for 15% of the score. The formula estimates that people with longer credit histories are better to lend to than those who have just opened a line of credit. Also, it favors longevity with a lender versus those who have closed old accounts in favor of new lines of credit.

10% of your credit score is determined by how many new accounts you have opened. Any time you open a new line of credit it can temporarily lower your credit score.  While this may seem like a bad thing, opening new accounts for people with a limited credit history still improves their score because you must establish credit with a good payment history and ever increasing credit limits.

The kinds of credit accounts you open effects 10% of your score. Mortgages and car loans are better than credit cards. Credit cards are better than payday loans or title pawns. Having a mortgage makes you look more stable to lenders while having a payday loan and high credit card balances may indicate poor financial wellbeing.

Credit scores are convenient and they allow lenders to make decisions on credit quickly and conveniently for you and them. By building a credit profile that raises your credit score, consumers can make better decisions about credit and have more options to get credit at a lower cost.

Are you having trouble with your credit? Are lenders or collections agencies harassing you?  If they are there’s a good chance they have already had a negative impact on your credit score.  Come see the attorneys at Harmon and Gorove today for a free consultation about how we can change your financial situation through the bankruptcy process and start your on the road to rebuilding your good credit.