Credit scores are numerical representations of an individual's creditworthiness, typically ranging from 300 to 850. They are calculated based on information from credit reports, which detail an individual's credit history, including payment history, amounts owed, length of credit history, new credit, and types of credit used. The most commonly used credit scoring models are developed by FICO and VantageScore, each utilizing different algorithms that weigh these factors differently.
Payment history is the most significant factor in determining a credit score, accounting for approximately 35% of the total score. Late payments, bankruptcies, and foreclosures can severely impact this aspect. It's noteworthy that a single missed payment can remain on a credit report for up to seven years, affecting a score long after the fact. Conversely, consistent on-time payments can improve a score over time, highlighting the importance of maintaining a good payment record.
The second most critical factor is the credit utilization ratio, which represents the amount of debt a person owes compared to their total available credit. This ratio is ideally kept below 30%; exceeding this threshold can lead to a drop in credit scores. Interestingly, having no credit cards or revolving credit can also negatively impact a score, as it limits the data available for lenders to assess creditworthiness.
Length of credit history, making up about 15% of a credit score, considers how long accounts have been open. A longer history provides more data, potentially leading to a higher score. It’s also beneficial to keep old accounts open, even if they are not actively used, as they contribute to the overall credit age.
New credit inquiries, which account for about 10% of a score, occur when a lender checks a consumer's credit report for lending decisions. Each hard inquiry can lower a score slightly, but the impact diminishes over time. However, multiple inquiries within a short period can signify risk to lenders, especially if they appear to be shopping for credit.
Finally, the types of credit used—encompassing credit cards, mortgages, and installment loans—constitute about 10% of a score. A diverse mix of credit types can positively influence a score, as it demonstrates an ability to manage different types of debt. However, this does not mean one should open unnecessary accounts, as doing so can lead to increased debt and financial strain.
Understanding credit scores is crucial as they affect many aspects of financial life, including loan approvals, interest rates, and even rental agreements. Individuals with higher credit scores often enjoy better financing options and lower costs over time, emphasizing the importance of managing credit responsibly.