It is pretty much common knowledge that you need a good credit rating in order to get a loan at reasonable rates. The higher your credit score is the better your rating will be, and the more chance you have of being approved for a low-interest loan. Over a 30-year period for a mortgage on your home the difference between a low or high interest rate can be staggering–literally thousands of dollars, which makes having a good credit score extremely important. Your credit score is calculated using a complex formula. Following is a brief explanation of the process.
How Information Is Compiled
The process begins when you pay your bills. A company, such as a utility company, supplies information concerning your account to a credit reporting bureau. There are three major credit reporting agencies. They are Equifax, Experian, and TransUnion. These agencies use the information accumulated concerning your payment habits to assign a credit score, which is comprised of a three digit number. The high your number is, the better your credit rating. Each company uses a slightly different method to calculate your credit score, but they are all referred to as a FICO (Fair Isaac Corporation) score.
FICO Formula
The Fair Isaac Corporation is a company that initiated the formula for calculating a credit score in 1956. They use a complicated system for the determination, based on 5 major categories. Many factors are taken into consideration within each of these categories. Although a lending institution may take your employment history, or other considerations, such as age, marital status income, or occupation into account when you apply for a loan, the FICO formula disregards all of these. Instead your credit score is determined by a combination of the following categories; payment history, the total of amount of debt you carry, how long your credit history is, any new credit you may have tried to establish, and the types of credit you have. These categories carry a varying degree of credence in calculating your credit score.
Percentage of Importance
Each of the above listed categories that are used to determine your credit score carry a different percentage of importance in calculating your FICO number. Your payment history usually accounts for about 35% of your total score. Following that is the amount of total debt you carry, which accounts for 30% of your rating. After that the amount of time you have had a credit rating is given 15% of the total credit score importance. The final two categories, any new credit you may have attempted to establish and the types of credit you make use of, each account for 10% of your credit score.
Credit Score Guide
The formula for determining your credit score is complex. A lot of things are taken into consideration, and each carries its own degree of relevance to your overall credit rating. Using a credit score guide can help you understand the process. Envision the guide as a pie chart broken down into its various components. The slice of pie attributed to payment history will be the largest. The next largest piece of pie in the chart will represent the total of amount of debt you carry. Another piece half that size will stand for how long your credit history is and the final two pieces will be of equal size and correspond to any new credit you may have tried to establish and the kind of credit you make use of.
What it All Means
Basically it all comes down to how much of a risk you will be considered when you apply for a loan. The higher your credit score is the better your chance of getting a low-interest loan. By putting more weight on certain areas of your credit history the number you’re assigned is the result of how you pay your bills and use credit. For instance, if you have a credit limit of $100,000 but are only using $25,000 worth of credit you will score high marks in the percentage of total debt used department. If, however, you are nearly at your $100,000 limit you may be considered a bad risk. In the same way if you have a track record of paying your monthly bills in a timely manner the all important payment history portion of your credit score will be high. But if you have repeatedly been late making payments, even though the payments may have all eventually been made, your payment history will be marred, and your credit score will be lower than it could be. While the FICO formula is complex, it serves its purpose.
