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Understanding Credit Scores
When you are applying for a credit card, it’s a good idea to know where you stand from a lender’s perspective so that you may select an offer that aligns with your eligibility. Your credit score obtained from your credit report is the main guideline that credit card issuer’s and other lenders look at when determining your credit worthiness. It is used to determine not only whether or not you will get approved for a loan or credit card, but the amount you will be rewarded and the pricing and terms of your contract. There are three major credit bureaus that provide credit reports and scores. Banks will usually look at one or two of these reports when you submit an application. The three major credit bureaus are TransUnion, Equifax, and Experian. Below you will find out how information from your credit reports are used to calculate your credit scores.
A credit score is a formulaic comparison of the major components that make up your credit report that is assigned a numerical value. The most common type of credit score is called a FICO score which ranges from 300-850. As a rule of thumb, individuals with excellent credit have scores ranging between 725-850, good credit are those in the 650-724 range, and those with bad credit are those with scores below 600. Scores that lie between 601 and 649 is a gray area and is sometimes called a fair or average credit score. Below are some general guidelines of what factors are used to determine credit scores and how they are used:
Length of Your Credit History
The length of your credit history, meaning how long you have had active accounts that have been reported to your credit score makes up roughly 15% of your credit score. The longer you have had active accounts in your credit history that have been in good standing, the better impact this portion will have on the calculation of your credit score.
An individual that has multiple credit accounts open in good standing is in a more favorable position than an individual with just one account. This shows that the consumer has the ability and level or responsibility to maintain several different accounts at once and keep them in good standing. This is weighted roughly 10% in credit score calculation.
This is weighted roughly 10% in your credit score calculation as well though it’s a bit confusing. The general belief is that it’s not good to have too many accounts open. However, if there are multiple accounts and they are all in good standing, this is a good thing so it’s a bit of a catch-22. The differentiating factor is how recently those accounts have been opened. If there have been multiple account inquiries over a short period of time it will be less favorable than accounts opened over a gradual period of time. There is some leeway with this when multiple inquiries have been made back to back as there is believed to be some weight given to the idea that consumers are more and more likely to “loan shop.”
Weighted at 35%, this is by far the most important element used when calculating credit scores. From a lender’s perspective it’s extremely important to know that a potential borrower will pay their bills on time as it is directly tied to their risk. Having clean accounts, meaning no accounts that have been past due and are in good standing is vital to an individual’s health as it directly relates to the calculation of this part of their credit score.
Debt to Credit Limit Ratios
The final 30% which is the second most important single factor when determining an individual’s credit score is their debt to limit ratio. This is defined as the amount of debt on open credit lines to the amount of available credit on the account (the credit line). The lower the ratio, the better the impact this will have on this part of the calculation however it is believed that having too low of a ratio isn’t optimal. Most believe that an ideal debt to limit ratio is around 25% or lower, 26%-40% is OK, and anything over 50% will draw red flags.
The calculation of credit scores is not an exact science. In fact, it’s viewed as less than perfect but currently it is the best solution. Because there are three different credit bureaus, all with different information available to them, scores may vary from bureau to bureau. Usually, a consumer will not know which bureau their credit report will be pulled from so it makes it that much trickier. It’s also impossible for consumers to calculate their own credit scores as the exact values and formulas are not readily available and are algorithmic. The above breakdown is the common understanding of how credit scores are computed but how the values are assigned remains a mystery. This is why many people as well as consumer advocates view the system as imperfect. Unfortunately, it’s all we have to go with at the moment so it’s important to understand how the system works and adapt accordingly.
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