What goes in to your credit score?
A lot of significance is given to your credit score in the consumer finance market. You will often be told you must have a good credit score be to get the best deals, be approved for lines of credit and have a chance of getting a mortgage. So what exactly goes into deciding your credit score and how is it calculated?
FICO is the major player in credit scoring. They have developed a unique and guarded algorithm that calculates your credit score from your financial history. They take the information within your credit report (provided by credit bureaus) and break it down into 5 distinct categories. Each of the 5 categories plays a role in determining your final score, with some weighted more heavily than others. Here is a breakdown of the 5 categories and their weighting.
1. Payment History (35%)
Your payment history plays the largest role in determining your credit score – specifically the repayment of past debt. According to FICO, your previous payment performance is a good indicator of your future payment behaviour, i.e. whether you are likely to repay a line of credit. The type of credit will also play a role in this category. For example, FICO suggests that a failed payment on a larger loan such as a mortgage will impact your credit score more severely than a smaller loan type or credit card.
To keep your score healthy you should you consistently pay your debt on time.
2. Credit Utilisation (30%)
Credit utilisation is the percentage of credit used that is available to you. For example, if your total credit limit on your credit cards and loans was R25,000 and you used R5,000, your credit utilisation would be 25%. FICO suggests that customers with the best credit scores tend to average around 7% credit utilisation, with 10-20% being OK.
This figure is seen as important as it is believed that individuals who are consistently close to their credit limits cannot handle debt responsibly.
As you can see, payment history and credit utilisation combine to make up almost two thirds of your credit score. If you are able to keep your credit card balances low and make payments on time, you are on your way to a good credit score. The remaining categories look at how long you have managed credit, what credit you recently applied for and the variety of credit you have handled in the past.
3. Length of Credit History (15%)
This category looks at the length of time your credit accounts have been open and the time since they were last used. This does mean it is almost impossible for new credit users to have a perfect credit score because they do not have enough previous financial activity to forecast future behaviours accurately. Our advice for new credit users would be to begin using a line of credit to build your history whilst existing credit users should maintain long-standing accounts, as it will be beneficial to your credit score.
4. New Credit (10%)
FICO suggests that applying for too many lines of credit in a short space of time could negatively affect your credit score as it suggests you may be in financial trouble and need access to money. It is recommended that you apply for credit when it is needed and in moderation.
5. Credit Mix (10%)
The specifics of this category are less well outlined, however it is believed that a consumer with a variety of credit in their history will have an improved score as it demonstrates they are capable of handling different types of debt. FICO indicates that consumers with a variety of revolving credit and installment loans in their history prove less of a risk to lenders.
This breakdown should give you a better understanding of how your credit score is formed and where to pay particular attention if you wish to improve your rating over time.