As discussed in 'What's a Credit Score?' post, FICO is a software most major lenders will use to decide whether to extend credit to customers and at what interest rates.
So how exactly does FICO determine your credit score?
There is a secretive algorithm behind the inner workings of the FICO scoring scale. But generally, there are five components that make up your FICO credit score: Payment History, Credit Utilization, Length of Credit History, New Credit, and Credit Mix.
1. Payment History
According to FICO, past long-term behavior is used to determine future long-term behavior. The most important factor in terms of your FICO credit score, is your payment history. Payment history comprises 35% of the total credit score. FICO will watch multiple lines of credit such as revolving loans, e.g. credit cards, and installment loans, e.g. mortgages or student loans. Tommy Lee, a principal scientist at FICO, states that "FICO scores consider the frequency, recency, and severity of reported missed payments." Therefore, the best way to improve your credit score is by making consistent, timely payments.
2. Credit Utilization
Credit Utilization comprises 30% of your total credit score. Credit utilization is defined as the percentage of the available credit that has been borrowed. FICO views people who cannot handle debt responsibly, as borrowers who typically always max out credit cards, or borrowers who get very close to their credit limit repeatedly. Therefore, maintaining low credit card balances will benefit you in the long run. FICO states that people with the best scores usually have an average credit utilization of less than 6% with 3 accounts carrying balances and less than $3,000 owed on revolving accounts.
3. Length of Credit History
The length of your credit history is the length of time each account has been open and the length of time since the most recent activity on that particular account. The length of your credit history will make up approximately 15% of your total credit score. A longer credit history will provide more information of long-term financial behavior. If you do not have a credit history, it is best to begin using credit. If you do have credit, keep maintaining long-standing accounts.
4. New Credit
New Credit makes up 10% of your total score. New credit is simply when you open a new line of credit. It is best to not open too many credit lines at ones. This behavior could suggest that you are in financial trouble by needing access to lots of credit. Lee states that customers should only apply and open new credit accounts when needed, and "new accounts will lower your average account age, which will have a larger effect on your FICO scores if you don't have a lot of other credit information."
5. Credit Mix
Credit mix makes up the 10% of your total credit score. Having a good mix of credit, or repaying a variety of debt products, indicates that you can handle all sorts of credit. FICO indicates that borrowers with a good mix of credit and installment loans generally represent less risk for lenders. Lee explains that “people with no credit cards tend to be viewed as higher risk than people who have managed credit cards responsibly.”
Knowing these various weights given to the components of a FICO score can give you a better idea on how to build your credit.
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