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Understanding Your Credit Score

Wednesday, November 9, 2011 3:43pm
Magnifying glass over words "Credit Score"
Credit scores represent how much of a credit risk borrowers are to lenders. Particularly for unsecured loans, like personal loans, a borrower’s credit score must meet a lender’s expectations.

Credit scores are determined from information held by several credit bureaus, but are congregated into a single report by a company called Fair Isaacs Corporation, more commonly known as FICO.

FICO is the creator of a complex algorithm that determines the risk an individual poses to lenders. Unfortunately, that algorithm is kept under lock-and-key and is constantly changing, so nobody outside the corporation knows the exact factors that cause borrowers’ scores to rise or fall, but FICO has provided some general hints as to how scores are determined.
 
There are five main factors:

  • Payment history (35%)
  • Current debt (30%)
  • Length of credit history (15%)
  • New lines of credit (10%)
  • Types of credit used (10%)
 
Each of these factors contains many facets FICO considers when determining how to rate an individual.

Payment History

A person’s past carries the most weight when determining how risky that person will be when it comes to financing in the future. When considering how creditworthy an individual is, FICO looks at individuals’ rate of delinquency, duration of all delinquencies and their ability to remedy a delinquency.

Current Debt

The amount individuals owe when compared with their account balances can negatively impact their score because FICO has to assume an individual can only handle so much at any given time. Consider two similar individuals making the same out of money. Both apply for a loan, but one of those individuals has a large existing auto loan while the other does not. In FICO’s eyes, the one without any debt would be more capable of paying off a new line of credit, and thus may earn a higher score.

Length of Credit History

FICO likes to use the past to measure the future. If FICO is scoring a young 18-year-old teenager with an established job and salary, FICO will still take its lack of knowledge of the teenager into account. After all, the teenager has yet to prove to the financial world how responsible he or she is when it comes to making good on a debt.

New Lines of Credit and Types of Credit

The number of newly opened accounts an individual has draws the attention of FICO, and usually in a negative light. It may seem like a person ought to receive a benefit if they have many lines of credit open while still making good on their debt, but FICO sees those individuals as risks. Like the length of an individual’s entire credit history, new lines of credit have yet to be tested in the eyes of FICO.

The types of credit somebody has also carries weight. A credit card from a clothing store (or multiple cards at that) is not as telling as a home mortgage. Likewise, taking out many high-risk loans, or carrying a balance on many credit cards simultaneously (despite paying those balances off on time) raises FICO’s red flag.

All five of these factors are considered by FICO, and your score is being constantly updated. If your score is lower than you’d like, or in the event it drops, it is still possible to raise your credit score. With the right knowledge, motivated commitment, and hard work, anybody can climb upwards on FICO’s credit ladder.