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"Creditors have better memories
than debtors."

Benjamin Franklin
How Your Credit Score is Figured

Your credit score is an important part of your overall financial health. People with poor credit scores may have problems signing a lease, buying a car, or even getting credit for small items. Good credit is almost required to buy a house or get a decent interest rate on a car loan. Some prospective employers even look at a credit report before deciding who gets hired. While most of us know that we need a good credit score, few of us really know what it is.

First of all, your credit score is not really one thing. In the 1980s, a company called Fair Isaac & Company (FICO) came up with a rating system that considered a variety of factors and came up with a number to provide a “snapshot” of your credit worthiness. The FICO system is the most widely used credit scoring system in America today.

However, you don’t really have one credit score. There are three major credit bureaus in the U.S, (Experian, TransUnion, and Equifax) and each one uses its own variation of the FICO score. On top of that, your credit score changes frequently.

The fact that credit scores change is both a good thing and a bad thing. If you have a good credit score today, you can’t necessarily count on retaining it unless you keep up the good work. By contrast, if your credit score is bad today, you won’t necessarily be held back by it forever if you start to clean up your act. Your credit score should keep up with you, so if your financial picture gets healthier, your score will, too.

At the risk of getting overly simplistic, your credit score is based on five different categories and each category involves many different pieces of information. This means that one late payment (or one promptly paid-off debt) will not have a tremendous impact on the overall credit score. Instead, the score tries to capture a well-rounded picture of how you manage your debts. It's a "big picture" metric for how you manage your debt.

The lion’s share of your credit score involves what is called “payment history.” This category, which can make up as much as 35% of your total credit score, is the place where things like bankruptcy, late payments, and defaulted loans are counted. However, the number is not a permanent thing, frozen in time. A late payment will hurt this score, but timely payments help it. And eventually, things are programmed to “get off” your credit report. For instance, if you sign up for debt relief, that will definitely affect this portion of your credit report but for just three years. Even a bankruptcy, which is generally regarded as the most severe form of financial failure, stays on the books for ten years and then goes away.

Another important element of your credit score (about 30%) is the “amount owed.” A key element here is how much total credit you have and how much you’re actually using. You get high scores if you have much more credit at your disposal than you use. For instance, if you have a credit card that’s maxed out, that shows that you pretty much use up every scrap of credit anyone will extend to you. But if you have a credit card with a $5,000 limit and there’s just $500 on the card, that earns you good marks. It means you have the discipline not to use all of the credit that you have. You won’t do well in this department if you max out all of your cards. The best way to get a good score here is to have high limits and not use them.

You also get rated on “length of credit history,” and there is not much you can do about this. The thinking behind this category is that it is riskier to lend money to a person with little or no track record than it is to lend money to a person who has demonstrated in the past that she can pay off what she borrows.

Credit history is not based on your age. In fact, age is one of the things your credit score absolutely does not encode (others include race, gender, and where you live). A 40-year-old housewife applying for her first credit card counts as just as “new” as a 17-year-old student getting his first credit card.

Other items in the score are “new credit” and “types of credit.” New credit is actually not how many new loans you get so much as how many times requests have come in to see your credit report. The thinking is that any time you apply for a new card, take out a new loan, or try to negotiate with a creditor, your report will be pulled. A lot of activity in this department can lower your score. However, the impact is not all that great and your credit score looks only at activity in the past year. Thus, applying for a new credit card can depress your credit score, but the effect will be short-lived.

Types of credit applies a special formula to the different types of debt you’re carrying. There is no magical recipe of how many loans versus how many credit cards you should have, but it does try to see what sort of financial balance you’re maintaining. If you have lots of high-interest credit cards and no other types of loans, that would be the kind of imbalance that earned you a lower score.

All of these factors are assessed using lots of data (figure that the score should be looking at every payment you make or don’t make, every debt you have, every time anyone requests your credit report and other information all gets blended together). The result is a moving target in the form of a score.

There are some things you can do to improve your credit score.

First, you have to pay your bills promptly (late payments hurt) and not default on payments.

Second, you should try to pay down maxed-out accounts so that you’re not using up all of your available credit.

Third, don’t keep applying for more cards.

Last but not least, be patient. The great thing about credit scores is that one misstep or a bad spell will not haunt you forever.

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