Your FICO credit score is a number that can end up costing you lots of money or saving you lots of money. Knowing how to maintain a good credit score can mean a difference of hundreds of thousands of dollars.
The standard metric of a person’s creditworthiness is the FICO credit score with a range of 300 to 850. Consumers with higher credit scores are typically offered lower interest rates on lines of credit such as credit cards, car loans, and mortgages.
According to the Fair Isaac Company, on a 30-year fixed mortgage of $100,000, a FICO score of 720 gets a rate of 4.769% APR with a monthly payment of $1,568 while a FICO score of 620 gets a rate of 6.136% APR with a monthly payment of $1,825. Over the course 30 years, the higher FICO score leads to savings of $92,520.
So, there is a major financial benefit for keeping a good credit score. Additionally, understanding how your credit score is calculated would reveal areas where you can work on to improve your creditworthiness and what you should not do to remain a low credit risk.
Your FICO score is calculated with a top-secret proprietary formula based on the following five components:
1. Payment History (35%)
The portion of your credit score that has the most impact is your payment history. Debts that are paid on time will not appear as a negative mark on your credit report. Recent payment activity has a greater significance than older activity. Your payment history includes deliquent accounts and accounts sent to collections agencies. Declaration of bankruptcy will completely destroy your credit score.
2. Amounts You Owe and Credit Limits (30%)
This portion covers your debt utilization ratio, which is the total amount you owe divided by the total amount you borrowed (and/or can borrow). Your outstanding debt includes every single line of credit you own – credit cards, auto loans, mortgages, HELOCs, and others.
A low debt utilization ratio is better for your credit score. If you have $100,000 in available credit but only owe $1,000 on a credit card, your debt utilization ratio is only 1%. If you owed $90,000, you are using 90% of your available credit, which seems like you are barely able to get by.
3. Length of Credit History (15%)
The ages of your accounts, whether open or closed, plays a sizable role on your credit score. The longer you’ve had credit, the more experience you’ve had with debt management – and the higher your credit score.
4. Types of Credit (10%)
Having an assortment of revolving credit, such as credit cards, and installment credit, such as mortgages shows you can handle different types of debt. A mix of credit exhibits experience with various kind of credit that makes you less of a credit risk for those types of accounts in the future.
5. New Credit Inquiries (10%)
Every time you apply for a new line of credit, it is recorded on your credit report whether or not the application is approved. Multiple credit inquiries in a short period of time will pull down your credit score as it appears desperate. New inquiries will have a greater impact on those with short credit histories or a debt utilization ratio.
To obtain a FICO credit score, you must purchase it directly from FICO but there are other free credit score alternatives that don’t use the same exact formula as FICO. Nevertheless, they can be a good metric for monitoring your credit and estimating your real credit score.