This is a guest post by Hank Coleman. Hank Coleman is a Captain in the United States Army and also the lead writer for several personal finance blogs, including Military Money Might and CreditScore.net. Be sure to follow Hank on Twitter @HankColeman.
While many people may not like the fact, a credit score is an important facet of Americans’ financial lives if he or she intends to borrow money in the future for a new car, home, or credit card. But, many Americans, both members of the military and civilians alike, are clueless as to how their credit scores are calculated by the three credit reporting bureaus. Sadly, according to a survey conducted by The Monitor newspaper, 56% of people did not know that their credit score is the single most important factor when applying for a loan for a house, a car, or even a new credit card. Below are the five characteristics that the credit bureaus use to calculate your credit score.
1. Your Debt Payment History
Do you pay your credit card payments on time? Do you pay on time every month? Even though the credit bureaus keep how they calculate your credit score a closely guarded industry secret, your payment history is considered the most important factor in the calculation of your credit score. The credit bureaus also look at past due accounts, how long they are past due, if accounts are in collections, if you have had something repossessed, and other negative blemishes.
2. The Amount Of Debt You Owe
Of course, one of the largest determining factors for your credit score is the amount of debt that you owe banks and other financial institutions. The credit bureaus specifically look at the total amount of credit that you have been given or allowed to charge on a credit card, for example, and the amount that you have actually charged. This is called your credit utilization ratio, and the lower the number the better. So, for instance, if you have a credit limit of $10,000 on your credit card and have $6,000 charged, your credit utilization ratio would be 60%.
3. The Length Of Your Credit History
Many financial experts often recommend that a consumer not close credit card accounts if you have had the credit card for a long time because it will reduce your length of credit history. Your credit score will be higher if you have shown that you have successfully demonstrated that you can handle credit over a long period of time. The credit bureaus also look at how active or inactive an account is as well when determining your credit score.
4. How Much New Debt You Have
Every time you apply for a new credit card or a new loan, your credit score suffers. The credit bureaus look at the number of recently opened accounts and the number of recent credit inquiries as a potential red flag especially if it happens too often. You are given the benefit of the doubt though if you are requesting your own credit report or if you are shopping around for a good interest rate on a car loan or mortgage as long as you apply for the loans during a short window of time.
5. The Type Of Credit And Debt You Have
The final characteristic of your debt that credit bureaus look at is the types of credit and debt you have borrowed. Believe it or not, all credit is not considered equal in the eyes of a lender. The three credit bureaus weigh how much of your debt is comprised of various types of accounts such as credit cards, retail credit accounts such as a department store’s charge card, installment loans such as a car payment, mortgages, and other types of accounts. Those with the best credit scores have proven their ability to handle all types of credit successfully.
I am not a proponent of debt, adding more debt, or applying for more credit cards. But, we unfortunately live in a society that still revolves around the use of credit and borrowing. Not too many people are paying cash for a new home. So, in order to have a good credit score, consumers must understand how their score is actually calculated and the characteristics of their credit history that are used to create the score. Knowing those components will greatly increase a person’s chances of borrowing money at the best interest rates in the future.