Credit scoring is a complex process, a process driven by secretive software systems that are designed to evaluate the information contained in your credit reports and assign your credit scores based upon that data. If the information on your credit reports shows that you pose a higher risk to lenders then a credit scoring model will assign you lower credit scores. It probably will not come as a shock to you that higher credit scores can benefit you tremendously while lower credit scores can ultimately cost you a lot of money and cause a lot of unnecessary stress.
The unfortunate truth is that if you consistently struggle with poor credit scores then you could easily pay hundreds of thousands of extra dollars in interest over the course of your lifetime for your mortgages, auto loans, credit cards, and personal loans. For this reason, among others, it is a wise idea to learn everything you can about how credit scores are calculated and then use that knowledge to earn the best credit scores possible for yourself.
Credit Scoring by Category
Your FICO credit scores, the scores which are most commonly used by lenders, can potentially range from a low of 300 points to a high of 850 points. Altogether that means that you have up to 550 points up for grabs whenever a FICO scoring model calculates your credit scores. These 550 potential points are broken down into 5 separate scoring categories.
1. Payment History - 35% (or up to 192 available points)
2. Amounts Owed - 30% (or up to 165 available points)
3. Credit History - 15% (or up to 82 available points)
4. Mix of Credit - 10% (or up to 55 available points)
5. New Credit - 10% (or up to 55 available points)
*The points above are given for example purposes and are not exact.
For more information about these 5 credit scoring categories check out our previous article, Where Do Your Credit Scores Come From?
How You Earn Credit Score Points
Most consumers have a completely inaccurate view of how credit scoring works. For example, one of the most common questions I receive as a credit expert goes along the lines of "Michelle, how many points will "X" lower my credit scores?" or "How many points will I lose because of "X" action?" However, the idea that any action or item on your credit reports will lower your credit scores is actually incorrect due to the fact that credit scores are always built from the bottom up.
When analyzing the data on your credit reports credit scoring models like FICO will ask a series of questions (aka characteristics) about your credit report and the answers to these questions (aka variables) will ultimately determine the credit score you are assigned. Here is a hypothetical look at how the process works in reality:
The Question (aka Characteristic)
What is the age of the oldest account on the credit report?
The Answer (aka Variable)
· Less than 1 year old: 40 available points
· 1-2 years old: 50 available points
· 3-5 years old: 60 available points
· 5-10 years old: 70 available points
· Greater than 10 years old: 82 available points
*Hypothetical variables and point values were used in the scoring sample above.
There are quite a few other factors considered within the "Credit History" category of your credit reports as well, so the example above is really an oversimplification. However, it does serve to give you a better idea of how the credit scoring calculation process operates.
This question (characteristic) and answer (variable) exercise is repeated over and over again by the credit scoring model until all of the factors considered from your credit report have been completely analyzed. Next the points you earned above (based upon the variable which applied to your credit report) would be added to the points earned from the other credit categories and finally totaled together to come up with your overall credit score.
· Payment History Category = 150 points earned
· Amounts Owed Category = 120 points earned
· Credit History Category = 60 points earned
· Mix of Credit Category = 30 points earned
· New Credit Category = 40 points earned
· Overall Credit Score = 700 (Remember, your scores begin at 300, not 0)
The Story Continues - Scorecards
Now that you have seen a hypothetical example of how a FICO credit score might be calculated, it is time to complicate the story even more. Credit scoring models also have another component known as "Scorecards." Scorecards make up the framework or skeleton of any scoring model. They separate consumers into like or homogenous groups and each group is scored a little bit differently than the other. Therefore, if your credit reports are being scored by a scorecard designed for consumers who have filed bankruptcy you would not be eligible to earn as many points in each category as you would be eligible to earn if your reports were being scored by a scorecard designed for consumers with no derogatory information (aka clean files). For more information about scorecards, click here.
As mentioned above, credit scoring truly is a very complex process. However, what is simple to understand is that credit scores are generated solely based upon the information contained within your credit reports. Therefore, if you maintain credit reports which are free from negative information, keep your payments on time, and keep your credit card balances paid off monthly then you will be well on your way to credit score success. Understanding how credit scoring works is important, but as long as you focus on developing healthy credit management habits you can achieve and maintain the good credit rating you desire.
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Michelle Black is an author and leading credit expert with nearly a decade and a half of experience, a recognized credit expert on talk shows and podcasts nationwide, and a regularly featured speaker at seminars across the country. She is an expert on improving credit scores, budgeting, and identity theft. You can connect with Michelle on the HOPE4USA Facebook page by clicking here.