A credit score is a number calculated by using proprietary formulas or credit scoring algorithms based on consumers’ previous borrowing history and financial behavior. Credit scores represent how worthy of credit an individual is, and how likely she/he is to be able to pay off their debts. All sorts of lenders (banks, credit card companies, etc.) use credit scores as a tool to evaluate the risk of lending money or extending any other form of credit.
Common Types of Credit Score
Consumers do not have just one credit score; they have plenty of them and they are always changing and being updated with new information. There’s three major bureaus (Experian, Equifax, and TransUnion) who collect, store, and sell your financial history to creditors. Even though they all report similar information, there are often slightly different items (or even errors) being reported on the consumer credit files, which contributes to these variances in credit reports. Theres are also several scoring models which are used depending on the type of credit being sought after.
The scores most often used by grantors in lending decisions were introduced in 1989 by Fair, Isaac, and Co., known by FICO scores, and are calculated based on the information reported on the consumer credit files by the credit bureaus.
What Goes Into a FICO Score?
The main components taken into consideration when calculating a Fico score are:
- Payment history: 35% of the total credit score is based on a borrower’s payment history: Past debt, late payments, bankruptcy, liens, etc., which makes repayment of past debt and consistent and timely payments one of the best way of improving credit.
- Credit utilization: 30% of total credit is calculated based on percentage of available credit used. FICO sees borrowers who use up a large percentage of their credit as more risky and unable to handle debt responsibly. The FICO 8 model, which is the most widely used variant, suggests that consumers stay under a 30% usage-to-total-credit-available rate.
- Credit History Length: 15% of credit is decided by the history of your credit score. The longer it is, the more chances you have to increase your FICO score. This takes into account the average age of all your accounts, as well as the age of your oldest account on your credit report. An older credit history will provide more information, which is why it’s recommended that consumers keep their oldest account active and in good standing.
- New credit: 10% of your score is determined by new credit. Opening too many new accounts in a short period of time might suggest that borrowers are in desperate need of credit and that their finances are not in good standing.
- Types of Credit Used: this constitutes the remaining 10% of total credit. Fico considers that consumers who manage and pay on time a wider variety of credit (various revolving accounts, installments loans, mortgage) generally represent a smaller risk for lenders.
The other most widely used type of credit scoring model and FICO competitor is Vantage score. This was introduced in 2006 by the three major bureaus TransUnion, Equifax and Experian in an attempt to create a more uniform model.
With Vantage 3.0 (the latest version of this model) collections that have been reported as paid in full will no longer have an effect on your score calculation. Paid collections can stay on your credit for up to seven years: however, this model has decided not to take them into consideration. This way, the credit score of consumers trying to recover from past mistakes won’t be so weighed down.
Vantage 3.0 weighs similar and new factors when calculating your credit score.
- Payment history: Refers to timely and consistent payments. This is still the most influential factor when predicting risk.
- Age and Type of credit: Also very influential. This factor takes into account the length and the variety of the open accounts.
- Credit utilization: Debt-to-credit ratio.(highly influential)
- Total balances: Refers to current debt.(moderately influential)
- Recent credit: Refers to how many recent hard inquiries and new accounts are on the consumers file. Similar to new credit, it gives the idea of desperate need for credit.(less influential)
- Available credit: A high amount of credit available suggests that the individual can manage credit responsibly and that she/he is trusted by other lenders. This factor has, however, the least influence on the score.
Which credit scoring model lenders use depends largely on what type of credit the consumer is seeking (credit cards, auto loan, mortgages) making it possible for one person to have hundreds of credit scores. However, they all weigh in similar factors and any steps taken towards improvement will work on any of them.