Understand How a Credit Score is Calculated and Ways to Improve It

Your credit score plays a huge role in your current and future finances. For example, if you have a low credit score, you may pay a higher interest rate on credit cards or a mortgage. The higher your credit score, the more likely you can obtain credit when you need it. The first thing you should know is that a credit score ranges from 300 to 850. The lowest, 300, means you have poor credit and you are more of a financial risk to lenders and credit companies.

However, it’s also important to know that lenders look at more than one credit score. You actually have two credit scores: a generic score and custom score. A generic credit score is the one used by businesses and lenders to determine your general risk. This score is the score that ranges from 300 to 850. It is also the one used by all three credit reporting agencies.

This three-digit number is a snapshot of your credit health. It is calculated by scoring agencies. These agencies use an algorithm. This algorithm uses data such as loan payment history and your credit card balances. The purpose of a general credit score is to predict the likelihood that you’ll pay credit on time or become delinquent in payments.

The second score is called the custom credit score. This score is developed for individual businesses and lenders. A lot goes into determining a custom score. For instance, a lender replays on additional information such as account history and types of lending like mortgage or car loans. This means that you could have a higher or lower score than your general credit score depending on the lender you seek credit from.

Elements of Your Credit Score

One myth about a credit score concerns you have one generic credit score for all credit bureaus. That’s false. You have multiple credit scores, which may be different from each other. Why? Each credit scoring agency uses different scoring methodologies to determine credit scores. Also, each agency updates credit scores at different times.

However, your credit score is based on three categories of information:

1. Your credit history. A credit history refers to the types and number of accounts closed, open and active. These accounts include mortgages, credit card and auto loans. It also includes how old the accounts are, your payment history and account balances.
2. Collections and Public Records: The credit reporting agencies will list things like wage garnishments, foreclosures, bankruptcies and information from collection agencies.
3. Credit inquiries. Whenever you apply for credit, a lender pulls your credit. This may be a “hard” pull, which appears on your credit report. A “soft” pull are those that don’t appear on your credit report because they check your rate online and not your credit report.

Factors that Impact Your Current and Future Credit Score

You may not know this, but five things positively or negatively impact your credit score. These things are:

1. Your payment history. How you make your payments is the most important factor in your credit score calculation. This shows a lender whether you can make consistent on-time payments. Derogatory mark or a negative record on your credit report will occur if you are more than 90 days behind in payments.
2. How much credit you’re using. This is called a credit utilization ratio. You’re probably more familiar with the term of debt-to-limit ratio. It measures how much credit you’re using. It’s best to keep your credit utilization under 30 percent. It shows lenders you’re not overextended in your use of credit.
3. Type of credit. The mix of credit accounts and the number of accounts play a big factor in determining your credit score. Credit mix includes auto loans, credit cards, mortgages, lines of credit and student loans. The more credit accounts you have, typically the higher your credit score. This is also true about the diversity of your accounts. In both cases, it means that you’ve been approved for some type of credit by more lenders. Thus, you’re credit trustworthy.
4. Established credit history. How long you’ve had a credit history is a major factor in your credit score. A longer credit history will improve your score only if you’re consistently making on-time payments on open accounts. Age of your credit is also a factor. This means that the longer an account is open, the more you seem credit worthy.
5. New credit and hard inquiries. Remember, “hard” credit pulls was mentioned earlier. This can have a negative impact on your score because they stay on your report. In other words, each hard inquiry lowers your score a few points. Too many hard inquiries at one time will also lower your score drastically.

Increase Your Credit Score

If you have a good or high credit score, there are some things you need to do to keep it that way. Be thoughtful about closing accounts or adding new debts. These two things lower your credit score. Also, diversify your credit. If you intend on taking out new credit, make sure it’s only an amount you can handle and that it is different from your current open accounts.

Whether you have good or poor credit, make sure that you are only using 30 percent or less of your available credit. Using more than this amount will lower your credit score. If you have poor credit, you may want to obtain a secured credit card and make on-time payments consistently. This will improve your credit. Avoid too many hard inquiries. These inquiries remain on your report for two years. It typically takes six months for your credit score to return to the pre-inquiry level after one hard inquiry. In addition, check your credit report regularly. Errors on your report will lower your credit score too.