• A credit score plays a key role in a lender’s decision to offer credit.
• The FICO scoring system is used by many financial institutions.
• Factors considered in credit scoring include repayment history, types of loans, length of credit history, and an individual’s total debt.
• One metric used in calculating a credit score is credit utilization or the percentage of available credit currently being used. 
• It is not always advisable to close a credit account that is not being used since doing so can lower a person’s credit score.

   

  The credit score model was created by the Fair Isaac Corporation, also known as  FICO , and it is used by financial institutions.5 While other credit-scoring systems exist, the  FICO score  is by far the most commonly used. There are a number of ways to improve an individual’s score, including repaying loans on time and keeping debt low. 

  How Credit Scores Work

  A credit score can significantly affect your financial life. It plays a key role in a lender’s decision to offer you credit. People with credit scores below 640, for example, are generally considered to be  subprime borrowers . Lending institutions often charge interest on  subprime mortgages  at a rate higher than a conventional mortgage in order to compensate themselves for carrying more risk. They may also require a shorter repayment term or a co-signer for borrowers with a low credit score.

  Conversely, a credit score of 700 or above is generally considered good and may result in a borrower receiving a lower interest rate, which results in their paying less money in interest over the life of the loan. Scores greater than 800 are considered excellent. While every creditor defines its own ranges for credit scores, the average FICO score range is often used:

  • Excellent: 800 to 850
  • Very Good: 740 to 799
  • Good: 670 to 739
  • Fair: 580 to 669
  • Poor: 300 to 579

Credit Score Factors: How Your Score Is Calculated

There are three major credit reporting agencies in the United States ( Experian, Equifax , and Transunion), which report, update, and store consumers’ credit histories. While there can be differences in the information collected by the three credit bureaus, there are five main factors evaluated when calculating a credit score:

1. Payment history
2. Total amount owed
3. Length of credit history
4. Types of credit
5. New credit 3

Payment history counts for 35% of a credit score and shows whether a person pays their obligations on time. Total amount owed counts for 30% and takes into account the percentage of credit available to a person that is currently being used, which is known as  credit utilization . Length of credit history counts for 15%, with longer credit histories being considered less risky, as there is more data to determine payment history.

The type of credit  used counts for 10% of a credit score and shows if a person has a mix of installment credit, such as car loans or mortgage loans, and revolving credit, such as credit cards. New credit also counts for 10%, and it factors in how many new accounts a person has, how many new accounts they have applied for recently, which result in  credit inquiries , and when the most recent account was opened.

ADVISOR INSIGHT