The credit score, often referred to as a FICO score, is a proprietary tool created by FICO (formerly the Fair Isaac Corporation). FICO’s is actually not the only type of credit score, but it is the measure most commonly used by lenders to determine the risk involved in doing business with a borrower.
FICO Score Calculation
FICO does not reveal its proprietary formula for computing the credit score number. But it is common knowledge that the calculation incorporates five major components, with varying levels of importance. These categories, with their relative weights, are:
- payment history (35%)
- amount owed (30%)
- length of credit history (15%)
- new credit (10%)
- type of credit used (10%)
All of these categories are taken into account in your overall score—no one factor or incident determines it completely.
Each Category in Calculating Your Credit Score
Payment history takes into account whether you have paid your credit accounts consistently and on time. It also looks at previous bankruptcies, collections, and delinquencies. 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. The more problems you have in your credit history, the lower your credit score will be.
The next largest component is the amount you currently owe relative to the credit you have available. Credit score formulas assume that borrowers who continually spend up to or above their credit limit are potential risks. Lenders typically like to see credit utilization ratios—the percentage of available credit that you actually use—below 20%. While this component of the credit score focuses on your current amount of debt, it also looks at the number of different accounts and the specific types of accounts you hold. A large amount of debt from many sources will have an adverse effect on your score.
The other categories (length of credit history, new credit, and type of credit used) are fairly straightforward. The longer your credit accounts have been open and in good standing, the better. Common sense dictates that someone who has never been late with a payment over 20 years is a much safer bet than someone who has been on time for two years. Also, when people apply for credit a lot, it probably indicates financial pressures, so each time you apply for credit, your score gets dinged a little.
What Isn't Included
It is important to understand that your credit score only incorporates the information contained in your credit report and does not reflect additional information your lender may consider in its appraisal. Your credit report does not include, for example, such things as current income and length of employment. However, because your credit score is a key tool used by lending agencies, it is important that you maintain and improve it periodically.