Credit Scores - How They Are Determined

Everybody has heard about “credit scores”. But very few people know what formula is used to actually make up their credit score. The more you know about how your credit score is determined, the better you will be able to manage your credit so that your credit score will be as high as possible.

First off, you need to learn about credit scores. Since you already know that you have a credit score, I’ll show you the major points of just how your credit score is determined.

So what exactly makes a credit score high or low? Four major things are used in conjunction with each other to come up with your credit score. It all started with raw data.

The people that created the computer driven program that determines a credit score review a given number of consumers (usually millions at a time) that opened loans at the same time. Then they determine who paid the loans back on time and who did not.

They examine the histories of those that defaulted on their loans and look for similarities in the borrowers that failed to repay their loans. Using statistics discovered through this research, a computer program was designed that assigns different weights to each variable, commonly referred to as “credit score factors”, that are combined to create a single credit score.

Stripped of its verbal frills, the information that directly influences your credit score is usually four main items:

The number and length of late payments

Type, number, and age of accounts

Total debt

Recent inquiries

Let’s break them down one at a time.

The number and length or late payments

Obviously, it is better to have no derogatory information on your credit report; but since you are reading this I am assuming that there is some already. How does this affect your credit score?

A car payment that is reported thirty days late is not going to impact your score as severely as a car payment that is reported sixty days late. And one thirty day late car payment is not going to impact your score as badly as five credit cards that are each reported thirty days late.

Avoid making any mortgage payments late, since a thirty day late on your mortgage affects your credit score more than any other type of derogatory payment. One thirty day late on a mortgage payment affects your score almost as poorly as a bankruptcy.

If it comes down to a choice, pay your mortgage on time, and take the late payments on credit cards and department stores, since they do not carry as much weight on your credit report as your mortgage history.

Type, number, and age of accounts

The number of accounts open also influences your credit score. Too many open accounts makes lenders feel that you may become overextended and default on your monthly obligations. Also, accounts that have been established for a long time contribute to a higher score than more recently opened accounts.

Therefore, if you are going to close any open accounts, close the more recent ones first. Also, the kind of accounts you have directly affect your credit score. The more stable your credit history, the better your score will be. If you have nothing but five open credit card accounts, it would be very easy for you to just walk away and forget about them.

However, if you have a mortgage account, a car loan, and several credit cards, your score will be higher because you have debts that are tied to tangible assets; in other words, the lender will be able to recoup their loss through the repossession of the car or the foreclosure on the property.

The presence of a real estate loan on your report that has been paid on time tells a lender that you take your credit responsibly, and reflects very strongly on your report and score. The lack of real estate loans on your report does not mean that you are penalized score-wise; it usually means that your score is just not as high as it could be.

Total debt

Also, total debt on your open accounts is a significant factor in your credit score. This falls under the “account balance to high credit limit” score factor.

In other words, if you have a VISA card with a credit limit of $2000, and you carry a balance of $1900, your score will not be as high as it would be if you carried a balance of $500 with the same $2000 limit.

It indicates to the lender that you are a little more responsible, and do not immediately get a new credit card and run it up to its limit. If you can, attempt to pay down the balances on your open accounts. The effect on your credit score will be quick and dramatic. A general rule of thumb is to carry no more than 60% of your credit limit as a balance.

Recent inquiries

Last is the number of recent inquiries. There is always some confusion about this, so I’ll address it as accurately as I can.

The statistical models that have created the credit score computer program have shown that inquiries on your report are an indication of risk. The more inquiries that appear on a borrower’s credit file, the more likely the borrower is to accept more credit, which can create the possibility of a borrower becoming overextended.

The borrower may not be able to make all bill payments on time if there are too many of them. Naturally, not every inquiry means that a borrower has opened a new account; therefore the computer model does not assign as much negative impact to inquiries as commonly believed. Other information on the report, such as past payment history and use of credit, will often offset any negative impact of this one piece of information.

Also, credit reports only consider inquiries initiated by the consumer. These would be credit cards applications, auto loan applications, or mortgage loan applications. Inquiries that do not affect your score would be consumer requests for their own credit reports, lenders using the report for account review, any “pre-approved” credit offers you may receive, or inquiries for the purposes of employment.

Remember, your credit score is a very fluid number that will change as your credit report changes. Any change in your credit report such as removing derogatory information, opening new accounts, closing old accounts, or paying off open balances in full will positively impact your credit score. Knowing what things actually make up your credit score will help you in keeping your score as high as possible.