The Five Virtues of Great Credit
The following is provided for informational purposes only and is not intended as a form of credit repair.
If you’ve ever gotten a loan or opened a new line of credit, you know that your credit score is important.
Here’s something you might not know, however – the formula used to calculate your score is a secret.
A credit score is essentially a measure of your creditworthiness. It’s shorthand. Because lenders don’t have the time (or the inclination) to get to know you personally, they need a fast, objective way to see how risky it is to lend you money. Your credit score tells a potential lender how likely it is that you will follow through on your agreement.
Because there’s money involved (and often a great deal of money) it makes sense that lenders want a credit score they can trust. That’s why credit score providers, like FICO and Experian, keep the formula used to create your score a secret. If borrowers can manipulate their scores, then those scores are no longer an accurate gauge of risk, and if that’s the case, then the scores become meaningless.
Fortunately, just because we don’t know the whole formula doesn’t mean we’re completely in the dark when it comes to building strong credit. In fact, we have a pretty good idea what really matters when it comes to good credit.
How to prove your creditworthiness
All credit scoring models take into consideration the following five categories: payment history, amount currently owed to creditors, length of personal credit history, amount of new credit recently acquired, and types of credit currently in use.
How those factors are weighed in your score differs with each scoring model. FICO, which produces the most commonly used scoring model, weighs these five categories in this manner:
Each category says something distinctive about you and your risk as a potential borrower. In order to maximize your credit history and reduce your risk in the eyes of lenders, you should consider how your actions in each category impact your overall creditworthiness and act accordingly.
The most important category is also the simplest to master. A positive payment history includes no missed payments. Borrowers who do not fulfill their obligations are considered riskier than those who do. The circumstances behind a missed payment, unfortunately, do not matter. Make consistent, on-time (and in-full) payments and you will be on your way to an exemplary credit history.
Amount owed to creditors
An overextended borrower is a risky borrower. This is a complex category, but the standard rule of thumb has long been to avoid using more than 40 percent of the credit available to you. The closer you come to maxing out your available lines of credit, the riskier you appear in the eyes of lenders. Keep an eye on your debt levels, especially if you plan on applying for additional credit in the near future.
You can use this calculator to figure out how much of your credit line is still available.
Length of personal credit history
Lenders are most apt to feel comfortable lending money to a borrower who has been using credit successfully for many years. That’s why it’s important to begin using credit responsibly at a young age. A long history of smart credit usage will have a very positive impact on your credit score.
Amount of new credit recently acquired
As noted in the previous category, lenders like to see that you’ve been successfully managing your credit and loan accounts over long periods of time. When you’ve recently taken on new debt, it makes you riskier, because there’s no established history of success managing that account. This is why you may find that your credit score dips a bit after opening a new account. You need to prove all over again that you can handle the new debt. This is a relatively minor category, but it’s important to keep in mind, especially if you intend to acquire multiple new loans or sources of credit within a short span of time.
Types of credit currently in use
Building good credit is essentially a cycle of using today’s credit to prove to tomorrow’s lenders that you can be trusted with their money. In order to maximize your credit score and minimize your perceived risk as a borrower, you need to prove that you can handle many different types of credit. A borrower who has used credit cards responsibly, but has never shown that they can handle a loan, is simply riskier than a borrower who has successfully handled all types of credit.
A compass, not a roadmap
So even though we don’t have a map to a particular score, we know what direction we must travel in order to build a strong credit history. Focus on being the kind of borrower you would lend to, if the tables were turned. If you borrow wisely and fulfill your obligations, your credit score will reflect your true creditworthiness in due time.