Consumer credit scores came about thanks to the work of a company known as FICO, or the Fair Isaac Corporation. FICO is an analytics company that developed a “standard measure of consumer credit risk,” or a mathematical formula that calculates a person’s credit score. FICO then sold this formula to lenders so that they could learn more about their borrowers’ financial responsibility. Basically, a credit score predicts how likely a person is to default on their credit.
Credit scores are used by different lenders for different purposes. Most commonly they are used to approve people for loans and then to determine the terms and the interest on the loan. However they can also be used by landlords to approve someone for a house or apartment, cellphone companies as a qualifier for a contract, utility companies to determine your down payment, or even by insurers to set premiums. Because your credit score can greatly influence so many aspects of your life, it is crucial to understand how it is developed.
There are five different components that FICO uses to calculate a credit score, and each component accounts for a certain percentage of the overall score:
- Payment history – Whether or not you have paid bills on time accounts for 35 percent of your overall credit score. The more bills that are paid on time, the more your score will increase. Late payments can cause your score to drop.
- Credit utilization – Describing the gap between the credit you actually use and your credit limit, credit utilization accounts for 30 percent of your overall score. In other words, the larger the gap between what you actually spend and what your allowed to spend, the better your score.
- Length of credit history – How long your credit history is accounts for 15 percent of your credit score. The longer your credit history, the better. But don’t be discouraged; building credit takes time. It doesn’t happen overnight.
- Types of credit used – The different kinds of credit you have had makes up 10 percent of your total score, and variety is a good thing. Having different types of credit, such as loans, mortgages or credit cards, shows that you are confidant in managing multiple finances.
- Recent searches for credit – Credit searches, or credit inquiries, make up 10 percent of your score and can have a temporarily negative impact on it as they increase. Searches for credit happen when people attempt to find a new credit source, such as a new credit card. These inquiries do NOT include personal credit checks done on your own or by your employer.