Sunday, January 20, 2008

How A Credit Score Is Calculated

By Wade Young

A credit score is a rating designed to reflect how likely a borrower is to repay a loan. There is no such thing as a joint score, so married couples are rated individually. Also remember that credit scores have nothing to do with age, income, where you work or where you live. The rating is designed to rank a consumer on one factor and one factor alone -- likeliness to repay a debt. The exact formula for how the calculation is done is proprietary, meaning it is secret. There are, however, some things that we do know. There are five categories that make up a credit score. Here they are ranked by importance:

35% - Payment History

30% - Amount Owed

15% - Length of Credit History

10% - New Credit

10% - Type of Credit

Payment History -- 35%

Pay on time and your score goes up; pay late and your score goes down. There is some common sense to this too. For example, a 120-day late payment is more harmful than a 30-day late payment. The total number of accounts is also important. A consumer who pays cash for cars, has no credit cards and only one mortgage payment would be known as a "thin file." Established accounts paid on time boost your score. Open a few accounts, and pay on time. Do not close the accounts, or you will delete the established history. The longer your credit history the better. If you have a negative item on your profile, put that item in the past, literally. A negative item that is 90 days old affects your rating much more than a negative item that is 3 years old, which may have a negligible impact on your credit score. Every month that you pay bills on time moves your negative item deeper into the past. Because the credit scoring models place the most emphasis on the previous 24 months, work diligently to pay all your bills on time so that you have a clean history for at least the previous 24 months.

Amount Owed -- 30%

Aim to keep credit card balances at or below 30% of your total limits. The balance on any individual card should not exceed 50%. If you exceed these limits, you will be in danger of looking "maxed out" to the scoring system. Equity in an asset also helps your score. If you have a motorcycle that is almost paid off, for example, that will help your score. Your mortgage will reflect a high balance and a current balance. In the gap between those numbers resides your equity, and the larger the gap, the more your credit score will benefit. Paying down an asset is good for your credit score.

Length of Credit History -- 15%

Be careful about closing existing accounts because it deletes established history. Closing a VISA with established history can be devastating to your score. Your profile shows a "date opened" for each account. The longer your history the better. It is also important to use credit lines. An account that you have not touched in five years may not be helping your score even if you have always paid in a timely manner. Charging something on an unused card will often boost your credit score because it brings the established history current.

New Credit -- 10%

Opening new accounts can be detrimental to your credit rating. Opening a department store account to save 10% is a triple whammy. First, the credit bureaus frown on departments store cards. Second, the new card counts as "new credit," which is a negative in itself. Lastly, an inquiry will be placed on your profile by the store to see if you are creditworthy; that too will drop your score. Stick with 2-3 major credit cards, and leave it at that. Be wary about opening new accounts unless you have a compelling reason other than saving 10%.

Type of Credit -- 10%

Aim for a "healthy mix." Unfortunately, no one knows the exact recipe that the bureaus are looking for. It is safe to say, however, that they do not want to see the following profile: no mortgage, no car payment, one Gap card, one Victoria's Secret card and one Ann Taylor card. This would not be considered a healthy mix of credit. A mixture more likely to score well might be something like: one mortgage, two car payments, one VISA, one MasterCard and one American Express. No department store cards.

Copyright © 2008 Wade Young.

Wade Young is a Denver Mortgage Broker. His website is bursting with consumer information about credit scores and mortgages.

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