Few things in an American consumer’s life are as critical to their financial environment as their credit score – yet relatively few of us understand how the scores work, how the credit agencies calculate the scores, or even what number constitutes a “good” score. Let’s examine the credit score system and shine some light onto this murky and poorly understood aspect of your personal credit.
There are three major credit bureaus, but for the consumer’s purposes all three are functionally identical. The credit score is expressed as a single number, ranging from 550 or so at the bottom (any score below this point is considered extremely bad creditworthiness) to the low 800s at the top. (Each system has a different maximum, but they all peak in the low 800s.)
Many people think that the credit score reflects how rich a person is: if you have a higher income, you have a higher score. However, income is not considered as a factor in your credit score! In fact, the score measures, not your wealth, but how statistically likely the credit bureaus think you are to repay your existing or future debts. A poor man who pays every bill on time every month and never overextends his credit, will have a score far higher than a wealthy individual who is chronically skipping payments and is maxed out on every card.
In general, a score of 730 or higher is excellent, a score of 600-729 is adequate or good, and a score under 600 is bad credit. So how do the bureaus calculate these scores? The answer: nobody knows for sure (except the bureaus) because their algorithms are proprietary secrets. However, credit analysts have worked out the basic system by trial and error, and it looks something like this:
About 35% of your score is related directly to your payment history on credit card and other bills such as mortgage and utility payments. Recent payment history is weighed more heavily than past history, so paying your bills promptly for a few months can boost your score considerably. Defaults (such as bankruptcy), late payments, or write-offs (the creditor gives up on collecting the debt) are all poison to this category of the score.
Another 30% of your score comes from your available credit capacity. That is, if you have available credit, but have not used it, you are considered to be more responsible and thus more likely to pay your bills. This is why credit analysts recommend against closing credit cards when you revamp your personal finances. Pay off the card, then keep it with a zero balance, to maximize your score.
15% or so of your score comes from the length of your credit history, bad or good. Someone with a long track record of participation in the credit system is considered more trustworthy, even if they have been a poor risk in the past. 10% of the score comes from the amount of debt, or requests for new credit, in the last year or two. Filling out that “free” credit card application at the mall can actually ding your score by a few points; make 20 applications, or just buy a few big ticket-items on credit and don’t pay them back immediately, and your score can plummet by 70 or 80 points.