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Credit Scores: Personal Finance’s Biggest Mystery
As your financial planner will tell you, the higher your credit score, the more likely you are to be approved for loans and other forms of lending. But how does that magic three-digit number come to be? There’s more that goes into it than you’d think.
Your credit score is there to help banks, credit-card companies, and other lenders figure out how much of a risk it would be to lend you money or do business with you based on your past borrowing history. But how credit scores are calculated is a complex and mystery-shrouded process. While the criteria for credit scores is often clearly spelled out, no one quite knows for sure how the numbers are actually calculated, making them difficult to predict without handing your credit cards to a tarot reader.
FICO (Fair Isaac and Company, who created the system in 1958) is the most-used credit-score system in the US, with a scoring system from 300 to 850. The higher the score, the better one’s credit rating is. Using the FICO parameters, the main factors that compose your credit score are: payment history (35%), amounts owed (30%), length of credit history (15%), types of credit in use (10%), and opening new lines of credit (10%). VantageScore is another popular scoring system with its own similar criteria that issues scores from 501 to 990. However, it’s the next step that makes things more complicated. When you look up your credit score, it’s most often with one of the so-called “Big 3” credit unions—Equifax, Experian, and TransUnion—each of which uses its own calculations. That’s why the credit score you look up for yourself may not match the one your lender looked up for you. In fact, credit scores from the Big 3 may vary from one another by as much as 40 points.
Since the actual formulas for determining your credit score aren’t divulged, most experts agree that the safest bet for having a good score lies in always paying your bills on time and only carrying a small amount of debt. It’s also entirely possible to have errors in your file, which is why it’s important to check your credit report regularly and clear up any discrepancies. (By law, Americans are entitled to one free credit report per year from each of the Big 3 via annualcreditreport.com, though the actual scores are not included.) Should your credit score fall, there’s no magic method to improve it quickly, but the best first step is to pay down any debt you owe, which could start to improve your score in as little as 30 days.