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Understanding How a FICO Credit Score is Determined

Education | 02/28/2022 23:00

Credit scores always seem like a bit of a mystery. How are they calculated? Why do they seem to randomly increase or decrease?

That's why, today we're talking all about FICO scores; how they are calculated, what causes them to change, and why having a good credit score is so important.

And, perhaps most importantly, what we can do to increase our credit score. After all, whether you want to buy a house or refinance a car loan, your credit score matters.

Let’s look at how FICO credit scores are calculated and how you can increase your score.

A credit score is a number assigned to a person that indicates to lenders their capacity to repay a loan. The number is between 300–850 and indicates a consumer's creditworthiness. The higher the score, the more likely a person is deemed to pay back their loan. 

How Credit Scores are Calculated

Credit scores are calculated based on 5 different categories. 

  • Payment history (35%)

  • Amounts owed (30%)

  • Length of credit history (15%)

  • Credit mix (10%)

  • New credit (10%)

All of these categories contribute to your credit score, but some have a lot more weight than others.

Payment History

Do you pay your accounts on time? Do you miss payments? How many days past due are your bills? These are factors in your payment history score. If your payments are over 30 days late, your lenders will typically report it to the credit bureaus. You want to have a high proportion of on-time, full payments to make your payment history score high. 

Amounts Owed

The amounts owed category is a mix of how much money you owe, how much money you have available to you, and the number and types of accounts you have. An incredibly important factor in this is your credit utilization ratio, which is a ratio of how much money you owe compared to how much money you have available to you. This ratio should be less than 30%.

Length of Credit History

This category looks at how long you have had open and active accounts. How long have your credit accounts been established? How long has it been since you used certain accounts? The longer you have a history of having open accounts and consistently paying them, the higher your score will be.

Credit Mix

Your credit mix looks at how diverse your accounts are. Healthy credit mixes can include installment loans, mortgages, car loans, credit cards and retail cards. Having a good mix will give you a better score.

New Credit

This category looks at how many new accounts you have. If you have a short credit history with many new accounts, this will count against you. 

What Causes a Credit Score to Change?

There are three credit bureaus that calculate credit scores: Experian, TransUnion or Equifax. Creditors typically send updates to these credit bureaus monthly. 

There are many things that can cause a credit score to change. A missed or late payment, paying off a debt, or closing an account are just a few things that can change your score. 

But sometimes it feels like you really haven’t done anything different and your score has fluctuated. No missed payments, no closed accounts. Well, the reality is that your score is always fluctuating. This is because if you are consistently paying your bills and consistently using your credit, things are going to shift one way or the other.

Here are some of the most common reasons your credit score will fluctuate.

  • You reduced your overall debt. If you have paid down some of your accounts, such as your mortgage or car loan, it reduces your overall debt. This will increase your score even though you haven’t necessarily done anything (besides paying your bills regularly).

  • You reduced your borrowing limit. If you go for a long period of time without using one of your lines of credit, it could trigger the account credit limit to be lowered. This will increase your credit utilization ratio, which will have a negative effect on your score.

  • You paid off a loan. Wait, isn’t that a good thing? Well yes and no. It’s great to have one less bill every month and one less headache, but when the loan is paid off, it affects many parts of your credit score. It will cause your credit mix to change, your overall debt to reduce, and your borrowing limit to reduce. Also, if you paid your account on time it will no longer factor into your score as heavily. 

  • Time has passed. Time simply passing will cause your score to change. If you are not keeping your accounts active, it will count against you. 

  • A negative event expired. If your house was foreclosed on or you had to declare bankruptcy, this appears on your credit report. And it stays for anywhere between 7 and 10 years, depending on the event. As time goes on, their impact is reduced, and eventually they will be wiped from your report.

  • Identity theft. If there is a big swing in your credit report, it's possible that someone is using your credit to open unauthorized accounts. If you suspect this, request a copy of your credit report immediately and talk to the credit bureau.

Why is Good Credit Important?

So we know how credit scores are calculated, but why are they so important? The truth is good credit means a whole lot these days. Again, having a good credit score indicates to lenders that you are creditworthy and will pay back your debts. Having a good credit score can help with the following:

  • Lenders will approve you for lower interest rates on credit cards and loans

  • Lenders will be more likely to approve you

  • Lenders will give you higher credit limits

  • Insurance companies will give you better insurance rates

  • Landlords will approve you for rentals more easily 

  • You will have more negotiating power for loans and accounts

How Can I Increase My Credit Score?

If you want to increase your credit score, there are a number of things you can do in the long term and the short term. 

Make On Time Payments

Making consistent on time payments is the most effective way to increase your credit score. Remember, payment history makes up for 35% of our credit score, so this category is extra important as it carries the most weight. Try to set up for autopay if possible to ensure that you don’t miss a payment.

Request Higher Limits

Oftentimes credit cards will raise your limits automatically throughout the years. But it doesn’t hurt to ask for your limit to be raised. Raising your credit limit will raise your available credit and reduce your credit utilization score. This can score you some extra points on your score, as this part of your credit score accounts for 30% of your total score.

Pay Down Debt Strategically

Your credit utilization ratio looks at your overall debt compared to available credit, as well as your debt to available credit for each account. So if you have one account in particular that has a higher ratio, prioritize paying down that debt first.

For example, say you have two credit cards. One has a limit of $20,000 and a balance of $5,000. The credit utilization ratio for this account is 25%. The other credit card has a limit of $10,000 and a balance of $3,500. The credit utilization ratio for this account is 35%. You should prioritize paying down the debt on the second card to reduce that credit utilization ratio.

Check Your Credit Report and Dispute Errors

You should get in the habit of requesting your credit report three times per year. It is free to do so once per year from each of the three credit bureaus. When you get your report, look over everything carefully. Cross check your payment records and credit limits and make sure nothing is misreported. This will also help you catch any fraudulent activity that may be brewing.

If you notice any issues or irregularities, report them to the credit bureaus immediately. They have 30 days to investigate and respond, so the sooner you report any issues, the better.

Refinance Your Car Loan

You are probably wondering “does refinancing affect credit scores” – and the answer is yes. In fact, a great way to improve your credit score is to refinance your car loan. It will not instantly raise your credit score (on the contrary, the hard inquiry on your account will temporarily ding your score). But refinancing your car loan can help you out in the long run. 

Refinancing your car loan when market rates are low will help you secure a lower car loan APR. And this can save you lots of money every month, not to mention overall. It will ultimately free up more money every month so that you can pay off other debts and ensure that other payments will not be late. 

And that’s everything you need to know about credit scores.

Put in the time and effort to make sure you have a good credit score. It will pay off tenfold in the long run. 

If you have a good credit score but want to bump it up to the next level, consider refinancing your car with Auto Approve. We can help you save loads of money every month, and who couldn’t use some extra cash?


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