This is How They Calculate Your Credit Score

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One of the most crucial steps towards Financial Freedom is paying off debt, so that you can increase your disposable income to build up your liquid investment base. More than this, paying off debt is important because it frees up your credit so that you can use it to build up your passive income base.

Your credit score is the lifeblood of your efforts towards Financial Freedom. It determines how profitable your investment pursuits are and ultimately how quickly you can grow your income base. The best way to be poised towards attaining wealth quickly is to have a good credit score, so that lenders want to finance you and are willing to do it at the lowest rates.

All of this is good and well, but it’s very hard to know what affects your credit score positively, or negatively, if you have no idea how the consumer credit reporting agencies go about calculating your credit score.

This article seeks to help you know a little more about the calculation of your credit score. It must be noted that consumer credit reporting agencies do change their algorithms from time to time, but because this is a legislated industry, those changes aren’t usually drastic and all the major changes should be published by the credit regulator should you be looking to keep abreast with the latest on credit regulation.

Okay, let’s get into it!

Credit Score Factors

There are roughly 30 unique factors that are used to calculate your credit score. All of these factors are derived from your credit report.

I will outline a high-level view of the major factors and then give a basic breakdown of what the consumer credit reporting agency will look out for. I will start with the items with the heaviest weighting and make my way down to those with the least.

Payment History (35%)

As you may imagine, payment history has the largest influence on your scoring. This is the best way a stranger can get an idea of how you interact with your lenders after you have been granted debt or financing. From a risk perspective, the lenders see this as a preview of what you may do to them if they were to afford you a credit facility.

The consumer credit reporting agencies, in particular, look at the following:

The Types of Accounts That You Have

The consumer credit reporting agencies like to see a variety in the types of debt that you successfully apply for. For instance, they would prefer it if your debt portfolio housed a mixture of secured debt and unsecured debt, short-term, medium-term and long term debt. They would look at this more favorably than if, let’s say, your only debt was in the form of five or six credit cards.

How You Maintain Your Credit Card Payments

It goes without saying that making consistent payments on your credit card debt will be looked upon favorably. They also look to see if you make only the minimum prescribed payments, or if you pay them down faster when you can.

Mortgage and Instalment Loans

These are assessed through a slightly different lens than credit card payments since more of this kind of debt is secured like vehicle hire purchase and mortgage loans (not always, take for instance a personal loan), but in all cases, this debt is a bit more biased towards medium and long-term.

Comments on Late or Missed Payments

Although the credit system, all things considered, is unsympathetic to real-life situations like delayed salary payments, retrenchments, loss of employment and unemployment, there is an allowance for comments around these kinds of situations. It should be said that, leniency you may be afforded in situations outside of your control, are of very little effect on protecting your score from harm.

My advice is not to link debt to your salary, and to build up a savings base as a hedge to keep your credit score protected under all circumstances.

Collection and Public Record Items

If your accounts have ever reached this stage with your creditors, this is where they will appear. As you can appreciate, this will affect your scoring quite heavily

Outstanding Debt (30%)

The Amount You Owe on Different Kinds of Accounts

Under this parameter, the consumer credit reporting agency looks at your total exposure to debt. They will assess this amount in contrast to how much you earn. This will give them an idea of whether your appetite for debt is healthy, or excessive. In other words, if you had less total debt spread across the same amount of credit facilities, you would be looked upon more favorably than if you had the same amount and types of facilities but had a larger total amount of debt.

How Close You Are To Each Credit Limit

Once again, a similar principle is used here, only, here they can isolate individual credit accounts. Say, for instance, your total exposure to debt was perceived as safe, but you had two credit cards that you had “maxxed-out”, this would be detected and flagged under this parameter and your credit rating would be commensurately affected.

The best way to use your credit card is to keep your use below 30% of your credit limit. Say you have three credit cards, each with a credit limit of $1,000.00.  You want to make a purchase worth $900.00. If you were to use a single credit card to do this, you would be using credit that is awfully close to your limit, and this would negatively affect your scoring. If you were to split the purchase across all three of your credit cards, this would boost your credit scoring as it paints a picture of temperance relative to your credit threshold, even though you have spent, in essence, the same amount.

The Number of Your Accounts That Have Balances

This parameter seeks to find out how comfortable you are with being in perpetual debt. Say, for instance, you had a good variety of credit facilities that you kept well below the reasonable thresholds, but you never paid off any of your accounts, you would be at risk of it all going pear-shaped if your circumstances were to change.

Creditors would like to see a picture that communicates to them that you use credit to achieve a goal and that you pay off the credit facility once its purpose has been achieved, and do not use the availability of the facility to find new reasons to be in debt.

Credit History (15%)

The Duration of Your Credit History

The longer your credit history, the better. Why? This tells the consumer credit reporting agency that you have endured various cycles and variations, but have thus far maintained a good relationship with your credit.

A shorter credit history leaves the risk that your behavior may change if your circumstances change, so it will, in their eyes, always be less reliable than a longer credit history.

The Durability of Your Accounts

This parameter measures how long you keep certain credit arrangements alive.

Just like people don’t trust somebody whose past is lined with a trail of breakups and the only common denominator is said person, nobody trusts somebody who serially opens and closes accounts.

This doesn’t show commitment. Hence, it is advised to keep accounts active even if you have paid them off and have no envisaged use for them per se.

The Frequency of Use of Each Account

A weird balance is required in this parameter.

The consumer credit reporting agency frowns upon behavior that seems to suggest that you use debt when you could otherwise pay for things upfront.

On the other hand, they also do not like to lack data points to work with and err on the side of caution when you don’t use your accounts often. With a lack of information, they will classify you as “risky until proven otherwise.”

Based on how much other debt we have, we can each use this piece of information differently. In other words, if you have very few accounts, you may want to try to find an innovative way of putting to use credit facilities that you don’t have much use for (I am not advising you to get into debt; making use of a credit facility and getting into debt are not the same thing). If you have a good number of accounts, you do not need to worry as much about making use of all your credit facilities regularly, and can simply ignore credit facilities that you don’t put to use much.

Types of Credit in Use (10%)

Number of Diverse Lines of Credit

This is a more high-level view assessing your credit mix. The more diverse, the better.

Type of Each Credit

Again, here, similarly a more high-level assessment of potential towards one type of debt. Say for instance having a lot of credit card (or clothing account) debt paints a picture of a person who always runs out of money before they do month, or an individual who spends impulsively. Whereas, a person who has a mixture of debt that included long term commitments may be seen to have more resilience and consistency.

Applications for New Credit (10%)

As you have gathered by now, the consumer credit reporting agencies love for you to be in debt, but they don’t like to see any signs that you take indebtedness lightly.

In order to avoid this negatively affecting your credit score, you need to think carefully before applying for new debt. Have a look at your current total exposure to debt. Have a look at how you have been servicing your individual credit facilities. Check to see if you already have a similar kind of credit facility or debt instrument in your debt portfolio. Most importantly, allow for breaks in between when looking to apply for more than one credit/debt facility.

Your credit score is hugely important to your financial planning. So, get a budget, start to save more money, pay off your debts and do whatever you can to improve your credit rating. It is your bridge to your wealth.

Were you able to identify what some of the reasons behind your credit not looking the way you would like it to may be? Let me know in the comment section.

Be sure to also check out Start to Fix Your Credit Now. Fast!, and, What Can My Credit Score Get Me?