How Your Credit Score Is Determined

There are a lot of myths that surround the concept of a credit score and credit history, so it’s a good idea to sign up to one of the services that can show you this information first hand.

Your credit report is simply a history of the payments you have made to credit accounts (be that loans, mortgages, credit cards, or phone bills), showing completed and missed payments. No judgement is made about these payments overtly, though lenders may make judgements from them. You will also find a credit score. This can be compared to your GPA at school, a running measure of your overall success compared to other students (or in this case borrowers). The better your score, the more credit-worthy you are generally seen by lenders.

What Is Your Credit Score?

The score is now also commonly used as a measure of your overall reliability. Everyone from your boss and landlord to insurance firms and business partners, may want to seek this out to help them make a judgement about how responsible you are. Gone are the days of it simply being used to determine whether you should be issued a loan and what interest rate will apply.

To keep things easy, lenders will have an internal bracket system and assign your loan an interest rate based on which bracket your score falls between. Similar brackets can be seen on your credit report itself, with terms such as poor, average, great etc. The most common score adopted by lenders and report agencies is the FICO scale, which measures your credit score between 300 and 850. An excellent score, where you can access most forms of credit and at good rates is generally over 740. You can still get credit below 650 but will progressively get fewer choices and higher rates. Anything close to 300 and no reputable lender will want to do business with you.

Internal scoring can also be very rigid from lender to lender. Just 15 points either way can completely change that amount of interest you’ll pay on a loan. This is especially true for mortgages where somebody with a 680 score could get as low as 4.7% over 30 years, whereas somebody with 665 would likely be charged over 5%. Over the lifetime of the mortgage that can be quite the sum of money.

How Is It Calculated?

While everyone knows that your credit score is calculated based on the credit history detailed in your reports from rating agencies, the exact factors and algorithms are not publicly known. FICO for example do not give away their specific formula, but they have revealed over the years that they strongly factor in your history of repayments, the amount you currently owe in outstanding debt, how long you have been active as a borrower (when you first got your credit card etc), whether you recently obtained credit, and the types of credit you use and have used.

The single most important element that goes in to your score and what most lenders are really trying to ascertain, is your payment history. Whether you have struggled paying or completely missed making payments in the past. This is a strong a sign as any that you are a reliable borrower or not. Even if you borrow a lot, so long as you meet the obligation your score should be ok.

Outstanding debt however is still an important part of the puzzle. If you have too much debt and your accounts are close to maxing out, new lenders will be concerned that you will be unable to take on any new debt.

Your utilization ratio is how much debt is outstanding compared to how much access to credit you currently have. For example you could have three credit cards at $3,000 each, but only have a balance of £100 on each. While there’s always a risk that you suddenly max them out, you are in a better position than having £2,000 on each card.

The longer you have been an active borrower, the more history you will have and the more data rating agencies and lenders can work with. This is good. If you have just taken out new credit your score may dip temporarily as your score and reliability is reassessed. It can therefore be difficult to take out lots of new credit at the same time.

The smallest factor, but still one worth considering, is the variety of credit accounts you own. If you can prove yourself responsible with loans, credit cards, mortgages, business accounts etc, you will get a better score than somebody in the same position who uses credit cards only.

Top Myth

A common myth among young people is that the less debt you are in the better your credit score, and you should avoid credit cards and loans if you can. This is not true. In order to build up a solid credit score you need to actively show your ability to borrow and repay throughout your life.

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