(Article Updated April 12, 2019)
Your credit score is a number that affects your everyday reality. It determines your ability to borrow money to purchase a home, take on a renovation project, and be approved for more competitive interest rates. But how well do you understand your credit rating and the factors that influence it?
If you’re like most people, you’re not clear on what shapes your score, but when it comes to financing a home, it’s critical that you do. Your credit rating is represented by a numerical score that describes the amount of financial risk you pose to lenders. It also shows how likely you are to repay debt. Simply put, the higher your score, the more willing lenders will be to extend you a loan or a line of credit.
FICO® and the three Credit Reporting Agencies
The most commonly known credit scoring term is a FICO score, named for the Fair Isaac Corporation. In the 1950s, Bill Fair, an engineer, and Earl Isaac a mathematician, developed a credit scoring system that went on to become the benchmark for all credit scores. FICO is actually the algorithm used by Experian and not the score itself.
The three largest U.S. credit reporting agencies, Equifax, Experian and TransUnion, all use algorithms to judge credit scores, and lenders will use an average of all three to determine your “qualifying” credit score, which is used to decide whether or not they will provide you with a home loan and at what interest rate.
Credit scores range from 300 to 850; with the average national FICO score for Americans being 704 in 2018 (average scores fluctuate, depending on the year, but typically hover in the high 600s and low 700s).
How your credit score is calculated
Here’s how your credit score is tabulated:
Payment history: Your payment history represents a whopping 35 percent of your score. While lenders may not expect balances to be paid in full immediately, they want to know if you will be consistent and on time with payments. That’s why it’s crucial for you to pay your bills each month by their due date even if you can only afford the minimum payment.
It’s very important to avoid getting negative marks on your credit report. This includes bankruptcies, delinquencies and payments that are 30+ days past due. In fact, having any late payments, especially multiple late payments for the same lender, can seriously damage your score.
Amounts owed. This number represents 30 percent of your score. This factor depends on your credit utilization ratio, which is a percentage of your total amount of debt in relation to how much available credit is left. Some experts say don’t use more than 30 to 40 percent of that available credit. A great way to quickly improve your score is to keep account balances low and avoid maxing out cards.
Length of credit history: This represents 15 percent of your score. Essentially, the longer you have held a line credit the more it will benefit your overall rating. Using a credit card and regularly paying it off benefits your credit to an even larger degree, but simply holding onto credit still helps, so remember to hold onto old accounts, rather than close them.
Types of credit in use: Worth 10 percent of your score, this relates to the types of debt you are carrying. Certain types of debt, such as mortgage loans, look better on a credit report than credit card balances. FICO scores consider all types of debts from student loans to retail store accounts.
Credit inquiries: Also worth 10 percent of your score, it’s worth noting that applying for multiple lines of credit at the same time can have an impact on your credit score. Lenders see multiple applications for credit in a short period of time as a sign of trouble – especially for people who don’t have a long credit history.
Keeping your credit clean is a tough job, but if you know what helps it and what hurts it, you will be in better shape for the future. When your credit score is in good shape and you’re ready to buy a home, speak with a loanDepot Licensed Lending Officer to get pre-approved for a home loan.
Looking for quick ways to improve your credit score? Check these out.
Originally Published September 13, 2016
loanDepot.com, LLC does not provide legal, investment, accounting or tax advice, please consult a financial expert for more information on this subject.