Your credit score is a three-digit number that lenders use to determine whether or not you are a trustworthy borrower.
Many lenders use the Fair Isaac Corporation (FICO) model for credit scores, which grades borrowers on a point range, with a higher score indicating less risk to the lender and a more favorable rate for you.
Take for example this credit savings illustration available at myFICO.com.
Borrowers with excellent credit scores — between 720 and 850 — save as much as $9,601 in interest over the life of a 60-month, $25,000 car loan compared to borrowers with scores ranging from 500 to 589. That is real money saved!
While the above example shows the effect of differing FICO scores on a hypothetical auto loan, the same principle applies to any other line of credit — credit cards, personal loans, mortgages, etc.
That’s why it’s important to know what factors are taken into consideration when calculating your credit score so you can take proactive steps in building good credit and qualifying for the lowest rates possible.
Payment History
Repaying past debts is the largest factor that makes up your credit score. Payment history amounts to 35 percent of your score and includes both revolving credit, such as credit cards, and installment loans, like mortgages. In short, payment history is used in credit formulas to determine future long-term payment behavior. Making on-time payments is one of the best ways to improve or maintain a high score.
Amounts Owed
The amounts owed factor accounts for 30 percent of your credit score. The formulas used to compute scores tend to see borrowers who reach or exceed their credit limit as a higher risk. Keeping card balances low can positively impact your score. Utilizing a high percentage of available credit will do just the opposite.
Length of Credit History
Opening a credit account early can pay off in the long run. The length of credit history factor, specifically the age of your first account, makes up 15 percent of your credit score. As time goes on, account holders with a positive history will have more data that influences their credit report.
New Credit
New credit amounts to 10 percent of your credit score. Opening new credit accounts on a whim can negatively impact your financial health, as it is a sign of greater risk. A 20-percent store discount for opening a new credit account may sound great, but it could make getting a loan, or a lower interest rate, more difficult. Only open new credit accounts when necessary to give your score a small boost.
Credit Mix
The fifth and final factor that contributes to your financial health is your credit mix. Credit mix is comprised of the various accounts you currently have open. This can include but is not limited to, credit cards, installment loans, and finance company accounts. Credit mix makes up the final 10 percent of your overall credit score.
Knowing the factors that affect your credit score can help you build and maintain a high credit score which will allow you to borrow from lenders at lower rates, saving you money in the long run.
If you are using credit cards to build credit, make sure you are using your available credit wisely, paying off the balances at each cycle, and only opening new lines of credit when absolutely necessary.