How Your FICO Credit Score Works
Everyone knows that you need a good credit score to qualify for a mortgage and get the best interest rates. But how are credit scores determined? What, if anything, can you do to improve a poor one?
For purposes of getting a mortgage, your credit score generally means your FICO score. FICO is an acronym referring to the Fair Isaac Corporation, which developing the FICO credit scoring system which is used by the three major consumer credit reporting companies: Equifax, Experian and Transunion.
Your FICO credit score is based on five main factors, and is proportionately weighted as follows: payment history, 35 percent of your credit score; current debts, 30 percent; length of credit history, 15 percent; new credit accounts, 10 percent; and types of credit used, 10 percent.
Payment history, current debt are key
As you can see, nearly two-thirds of your credit score is based on your payment history and your current credit debts. Your payment history generally means payments on various types of credit debt - credit cards, retail accounts, auto loans, mortgages, any type of installment debt. Things like utility bills and rent usually don't figure into the picture - unless the debt is delinquent or goes into collection - then it shows up as a big negative, the same as delinquent credit debt.
Your current debt refers to how much you owe on various accounts. Generally, it refers to how much of your available credit you've got tied up - a $200,000 mortgage may reflect less of a debt burden than $30,000 on your credit cards. A key factor here is something called credit utilization - how much of your available credit you've tapped. Owing $10,000 on your credit cards when you've got a $50,000 limit is only a 20 percent utilization - but owing $8,000 on a $10,000 limit means your utilization is 80 percent - and will have a much greater negative effect on your credit.
You can't do much about the third factor, the length of your credit history, other than wait a few more years for your credit history to become better established. It specifically refers to how long you've had certain accounts, however, so you're probably better off not closing out your oldest credit lines if you're looking to pump up your credit score, even if you don't use them much.
New credit refers to the number of recently opened credit accounts you have and their proportion to your total credit picture. Having a lot of new credit accounts can damage your credit score, so it's best to avoid doing things like opening new merchant credit cards to get a promotional discount when you're trying to build your credit score.
Using various types of credits will boost score
Types of credit refers to the various types of credit you have and have used - auto loans, credit cards, home mortgage, installment loans, etc. Generally, the more different types you've used, the better for your credit. On the other hand, you don't want to be carrying significant current debt on a broad variety of credit debt - that can hurt your score. What helps is when you've used lots of different types of credit and paid those debts off successfully - that shows you're a good risk for lenders and helps raise your score.
What doesn't affect your score, on the other hand, are things like income, employment, where you live, child support or alimony payments, age, marital status or similar personal factors. These may be taken into account by your lender in making their own determination whether to lend to you - they have their own standards they consider along with your credit score - but they won't affect your credit score per se.
If you're looking to raise your credit score, the best advice is to pay your bills on time. It's not fast, but an unblemished payment history is the best way to establish good credit. And it's much easier to knock your score down than build it back up - a year of on-time payments may raise your score only a little, but a single 30-day late payment can put a real dent in your score.
If you're just starting out establishing credit, it may help to establish and successfully pay off several different types of debt to help establish your credit history - credit cards, auto loan, retail accounts, etc. Successfully managing several small debts for six months or more could boost your score enough to get you a better rate on a mortgage.
Canceling excess credit cards can backfire
Generally speaking though, you don't want to cancel established credit cards or other lines of credit unless they have annual fees you want to avoid. Although getting rid of old and unused credit cards can help eliminate the temptation to use them, closing them out can also raise your credit utilization rate - if you had $50,000 credit line on 5 cards and owed $10,000, your utilization rate is only 10 percent - but if you cancel two of them and have a credit limit of $30,000, you're now using 33 percent of your credit - which looks worse on your credit report.
Understanding how credit scoring works can be complicated. That why Fair Isaac publishes a free 20 page guide providing in-depth explanations of how FICO credit scoring works and what you can do to boost your score. The booklet is available on the FICO web site at https://www.myfico.com/Downloads/Files/myFICO_UYFS_Booklet.pdf
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