What’s Behind A Credit Score?

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More and more people are taking charge of their finances by staying on top of their credit scores. There are a number of free websites that let users see their credit score whenever they like, and offer advice on how to improve their scores.

But what is a credit score?

Everybody seems to know that it’s a sort of magical formula that tells lenders if you’re a good (read: safe) bet to lend to, but how? And what does a credit score cost?

The most common score is known as the FICO Score, which comes from the name Fair Isaac and Company, who came up with the credit calculation formula:

  • 35% – Payment History; have you paid your bills on time? If not, how late were your payments? Have you had any debts written off or sent to collections?
  • 30% – Debt Burden; do you earn more than you owe? Commonly referred to as DTI, or debt-to-income ratio.
  • 15% – Length of Credit History; how long have you had credit? Is this your first loan?
  • 10% – Types of Credit; do you have accounts with established, accredited, well-known lenders? Do you have secured vs. unsecured debts?
  • 10% – Recent Searches; how often are you applying for loans/credit? Do you apply for a lot of loans?

While it seems straightforward, there are also a number of conditions that can seem contradictory to the average consumer. It’s better to have $150,000 of home debt (i.e. mortgage) than to have $1,500 of unsecured debt (that isn’t for any one specific thing). Also, you can improve your credit score by getting higher limits on your credit cards because it lowers your ratio of available vs. used credit. It is easier to get a loan for a newer, more expensive car than for an older, cheaper vehicle.

Even though these rules and guidelines can seem arbitrary and confusing, the secret is that it all comes down to security. Banks and lenders simply want to know that they aren’t going to lose money (they have to stay in business, after all). That’s why they’re willing to lend you $150,000 for a house (because they can take the house and sell it if you default on your loan) than $1,500 for nothing in particular (because what would they do with $1,500 of toys/video games/makeup/etc?). Raising your credit limits shows that you’ve proven to be responsible (you’ve shown you can pay back $500, so they’re willing to risk lending you $1,000), and that display of responsibility should be rewarded. Also, a new car will run longer and maintain higher value, so if (heaven forbid) you default on the loan, they can, again, seize the car and resell it to make up their losses.

The Good News.

The good news is that credit scores in the US have been growing slowly but steadily in recent years. Americans are paying their debts and, thus, the economy as a whole.

Knowing this credit formula helps consumers to make better choices with their borrowing habits, as well as overcome any fears they may have. Consumers who are looking to establish their credit can take comfort in knowing that their short length of credit history isn’t as harmful as they think. Also, don’t feel bad if you only have store credit cards (instead of a prime, unsecured card from a major lender), type of debt is only worth 10% anyway, a consistent history of always paying on time is going to make you look worlds better than someone with a platinum rewards card who always pays late.

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