How Are Credit Scores Determined?
I seem to get a lot of questions as to what is goes into a credit score and how it is calculated. While there is no simple answer to this question, we do know that credit scores are determined by the Fair Isaac Corporation (FICO). Their scoring model is of proprietary nature so we do not know EXACTLY how scores are calculated but they do give us 5 criteria of how they determine credit score.
The 5 criteria are as follows:
- Payment History (35%)
- Amount owed (30%)
- Types of Credit (15%)
- Length of Credit History (10%)
- New Credit (10%)
When applying for a mortgage we pull from 3 different Credit Reporting Agencies (CRA). They are Transunion, Experian, and Equifax. When deciding which score to use for the mortgage process we use the middle score of the 3.
Payment History (35%)
Payment history is the most important factor in calculating your credit score. It makes up 35% of your overall scores. Payment history includes no derogatory public records such as foreclosures and bankruptcies. Are you paying your bills on time with no recent late payments? Are there any collection accounts that are registered? If we have collection account we will want them to be resolved. It’s very important that we keep a clean payment history because past behavior is the best predictor of future behavior.
Amount Owed (30%)
The amount owed on current debts, loans, and credit cards is the second most heavily-weighted part of the credit score model. Do we maintain high balances on our credit scores? If we have a CC with a $5,000 dollar limit and a $4,999 balance this will have a negative effect on your credit score. This is because the credit reporting agencies like to see conservative use of our credit limit. If we have 3 credit cards and they are all maxed out our credit score will suffer as a result. A good rule of thumb is have a maximum of 30% credit utilization rate. This means we should never have a balance higher than 30% of our credit limit.
Payment history and the amount we owe on our debts make up 65% of our credit score. If we keep a clean payment history and keep our credit card debts low we are well on our way to a good credit score!
Length of Credit History (15%)
The length of credit history is worth 15% of your overall credit score. It is based off the length of time each of our credit counts have been open and active. The longer our accounts have been open and paid on time the better.
Types of Credit and New Credit (20%)
Types of credit and new credit round out the criteria CRA use to calculate our credit scores. Credit bureaus like to see that we are able to handle a variety credit. These include revolving debt, installment debt, mortgages, and auto loans. The final factor CRA’s look out is New Credit. Do you have recent inquiries for new credit? Have we applied and received 3 new credit cards in the last month? We want to be careful when applying for new credit cards because it can adversely affect our credit.
So while credit scores are not an exact science, these 5 factors are what Transunion, Experian, and Equifax use to calculate your credit scores. Credit score plays a VERY IMPORTANT role in the mortgage process. It affects things such as interest rate, mortgage insurance, and ease in which we go through underwriting. A 10-20 increase in credit score could save you thousands over the life of a loan. For this reason it is very important we maintain a clean credit credit history. You are entitled to a free credit report each year at www.annualcreditreport.com. I would highly suggest doing this to make sure there are no mistakes showing on your credit report. If you have any questions about your credit score or how to improve it, please give me a call at 443-786-9887. Applying for a mortgage is just a click away.
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