If you are like me every month, you open your most recent Discover Card statement (who provides your FICO credit score free of charge) and are eager to check out your credit score in the top right corner. Ok, so your credit score this month is 713. Or maybe it is 668. How about 571? What does this mean? How is your credit score calculated?
FICO is the credit score measure that is most commonly used by lenders to determine the risk that is involved in a particular loan. Due to the proprietary nature of the FICO score, the Fair Isaac Company does not reveal the exact formula it uses to compute this figure. However, what is known is that the calculation is broken down into five major categories with varying levels of importance. Let’s delve into these a little closer.
1. Your Payment history. If your credit score was a pie, the biggest piece would belong to your payment history. It accounts for 35% of your score. This means making on-time or late payments on all your credit accounts can really make or break you. The payment history category reviews how well you have met your prior obligations on various account types. It also looks for previous problems in your payment history such as bankruptcy, collections and delinquency. It takes into consideration the size of these problems, the time it took to resolve them, and how long it has been since the problems appeared. As such, the more problems you have in your credit history, the weaker your credit score will be.
2. Debt balance.The next piece is how much debt you owe, which makes up 30% of your score. Credit companies really like people who use less than 30% of their available debt limit. This means that if you have three credit cards with a total credit line of $10,000, you don’t want to ever carry a balance of more than $3,000 at once. While this category focuses on your current amount of debt, it also looks at the number of different accounts and the specific types of accounts that you hold. This area is focused on your present financial situation, and a large amount of debt from many sources will have an adverse effect on your score.
3. Length of credit history. 15% of your score is determined by how old your credit history is. In general, the older and stronger your credit history is, the better it is for your score. But even people who haven’t been using credit very long can have high scores, depending on how good the rest of their credit report is. Common sense dictates that someone who has never been late with a payment over twenty years is a much safer bet than someone who has been on time for only two.
4. New credit applications. Applying for new credit takes up 10% of the pie. If you apply for new credit every other month, that sends a red flag to credit bureaus. Also, people who apply for credit all the time probably already have financial pressures causing them to do so, so each time you apply for credit, your score gets dinged a little. A person with only one credit card is safer than a person with 10, so the more types of credit accounts you have, the lower your score will be.
5. Types of credit. As for the types of credit you have, this constitutes another 10% of your score. It is better to have low levels of revolving debt like credit cards and more kinds of non-revolving debt like a car loan or student debt. It just makes you look less risky.
The perfect FICO score is 850. Is it possible to even achieve a perfect score? Yes it is. In fact, according to the Fair Isaac Corporation, one in every 200 people (surprisingly) achieves the coveted 850 figure. Here are 10 tips on achieving a perfect credit score:
1. Pay your bills on time (and don’t be afraid to request a waiver if you’re late). As we discussed earlier, being on-time with your payments is the single largest component of your credit score. So, even if you have an occasional late payment, it’s often worthwhile to request that your lender forgive a late payment (assuming you’ve made your payment and are now current on your account). This is especially true of medical debt. When you default on medical debt, your doctor’s office or hospital will likely outsource it to a debt collection agency. The debt collector may then decide to notify the credit bureaus that you’re overdue on your medical payments, which could place a black mark on your credit report.
2. Set up as many automatic payments as possible. A great way to reduce the possibility of a late payment and eliminate the “I forgot” excuse that proliferates throughout the industry is to set up as many automatic payments as possible for your credit accounts. Having your bills automatically deducted from your bank account on a specific date or charged to a credit card (assuming you pay it off monthly) ensures that you are never late on your bills.
3. Don’t carry a balance if you don’t have to. If you can, pay your credit cards off each and every month. One of the greatest misconceptions is that you need to carry a balance on your credit cards to improve your credit score, which is not true. As long as you are paying your bill on time each month, then you’re going to see a long-term positive benefit in your credit score.
4. Don’t check your credit score each month. Another somewhat common misconception is that you need to stay on top of your credit score like a hawk. Your credit history can be compared to a roadmap that lenders use to decide whether to loan you money, and if so, what interest rates you’ll qualify for. It takes a lot of data points to paint an accurate picture for lenders. This means that your credit score can take a long time to adjust upward, especially given that your length of credit history contributes to about 15% of your FICO credit score.
5. Don’t be afraid to increase your credit limit. If you’re a compulsive spender, this may be a bad idea. However, higher credit limits (if used correctly) can help to actually improve your credit score. The higher your credit limits, the less likely you are to use more than 30% of your aggregate credit, which is the line-in-the-sand point where your credit score could be dinged. But over the long term it could help lower your credit utilization rate, which will have a considerably more positive impact on your credit score as long as you remain responsible with your spending.
6. Ask your lender to lower your interest rate. Sound insane? Asking your lender for a lower interest rate tends to work more often than not. Most cardholders don’t make this request because they are either afraid to do so or believe they’ll be told no. Give it a shot, you will be surprised to find out what banks and credit card companies will do to keep their best customers.
7. Keep good-standing accounts open and use them from time to time. One of the bigger errors consumers make is closing good-standing credit accounts because they believe credit card companies will view the action as “responsible”. In other words, consumers believe that by having fewer accounts, they’ll be demonstrating to lenders that they can responsibly manage their credit.
8. Only open accounts when it makes financial sense. An important factor in your march toward an 850 FICO credit score is to ensure that you only open new credit accounts when it makes the financial sense to do so. Opening a credit account makes sense when it’s an exceptionally large purchase, such as a house or car, or when it’s a large purchase that would strain your checking or savings account. In other words, avoid opening multiple new credit accounts just to save 10% on that $29 shirt you want.
9. Focus on your revolving debts first. Discussed earlier as well, if you happen to carry a balance on your credit cards, it’s important to focus on paying off revolving debts first. Whether you realize it or not, FICO actually takes the types of debt you pay into account when calculating your score. These two types of debt are revolving and installment. Revolving debts typically have higher interest rates and your minimum payment is based on the amount you owe. Department store credit cards are a good example. Installment loans are fixed loans of a lengthy time period, such as a mortgage or car loan. Paying down your revolving debts first often means paying less in interest.
10. Check your credit report annually. Last but certainly not least, make use of the fact that you can check your credit report once annually for free from each of the three credit bureaus. Far too many consumers fail to check their credit reports annually, and it’s more than likely that one or more of the three credit-reporting bureaus has an error on your report. Head to AnnualCreditReport.com right now if you haven’t done so yet this year and ensure that your credit report is accurate.
Now that you know how your score is calculated, you’d probably like to know how to see your score as well. It costs about $15 to get your score from MyFico.com. If you don’t want to pay for your credit score, many credit card companies have been adding them to their customers’ accounts as a kind of bonus. Barclaycard, First National Bank and Discover each provide their customers’ FICO scores for free. There are also plenty of free ways to check your credit score estimate online through sites like CreditKarma, Credit.com, Quizzle or Credit Sesame. Just keep in mind that these sites don’t give you your actual FICO score. They base your credit score on your credit history from one of the three major credit bureaus and then use their own algorithms to generate an estimate of your score.