The Truth About How Credit Scores Really Work

I get asked the question all the time; How Do Credit Scores Really Work? Here is an attempt to give you a little idea into this world. I hope it helps.

Nobody really knows the exact formula that is used to calculate credit scores. OK, some people must know, but it certainly isn’t public knowledge. The formula is derived from a supercomputer that uses mounds of data. Basically, when a lender pulls your credit, your credit report generates information that is put into the “secret” formula and your credit score is determined.

The three credit bureaus each use a different method for determining your credit score. Each method is similar but not exactly the same. All of the formulas are derived from the Fair Issac Corporation formula. If you want to check your credit score, don’t just check one bureau. Each bureau contains different information, so you need to check your report and credit score with each one.

FICO has released this breakdown of what factors affect your credit score.

On-time payments-35%
Lenders look to see how often you make on-time payments. If you want a good credit score, there is no excuse for ever making late payments. You have a better chance qualifying for the loans you want and getting the rates you want if lenders can see that you have a good history of making on-time payments.

Capacity used-30%
Your capacity used is the same as your debt to income ratio. Lenders check this to make sure you don’t have so much debt that you will never be able to pay all of it off. You should try to keep your debt capacity used under 30 percent of your income. This will give lenders an accurate representation of how well you manage your income.

Length of credit history-15%
Someone without any credit isn’t going to be approved for a $1 million dollar home, nor should they be. The longer your credit report is, the better your score will be. For instance, my husband has excellent credit. He has a good variety of credit lines, has never made a late payment, etc. His score is around 720. The only reason why it isn’t at 800 is because he has only had credit for about 8-10 years. The longer he has credit, the higher his score will get.

Types of credit used-10%
You want to make sure you have a good variety of credit lines. You don’t want the only thing on your credit to be 20 open credit card lines. Try to get a few revolving credit lines (such as a credit card), a mortgage, etc. The more variety you have on your credit, the better your credit will be.

Past credit applications-10%
If you have been applying for every loan possible recently, it will definitely affect your credit score. Try to keep your inquiries below 5 per year. The more inquiries you have on your credit, the lower your score will be. Lenders get worried when they see that you are applying for any loan under the sun. What happens if you get approved for all of those loans? Will you get way over your head in debt? Be careful about applying for too many loans. Keep is reasonable.

As you can see, each factor has a different weight in the FICO formula. Making your payments on time affect your credit score more than applying for a ton of credit cards does. It is important to keep all of these factors in mind each time you check your credit report and credit score. Understanding how credit works is a great way to increase your credit score by doing things the right way.

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