For many of us, maintaining a good credit score is a top priority in life. We may overlook getting that oil change or forget the annual physical at the doctor’s office, but we do everything necessary to pay our credit card bills on time, believing that on-time payments will maintain a high credit score.
In the past, this may have been true. Today-it is not the case, perfect payments don’t mean perfect credit scores. Here’s why.
How are Credit Scores calculated?
Your credit score, or FICO score, is essentially a calculation used by lenders to determine your eligibility for a loan, how much you can borrow and the corresponding interest rate.
Previously, your credit score was a mysterious, hidden computation that was primarily based on your payment history. Today, the breakdown of your score is a more clear-cut computation based on numerous important factors.
The five different factors used to calculate a score range of 300-850 need to be carefully examined and understood:
- Payment history. This portion focuses on whether or not payments were made on time. It accounts for 35 percent of the score.
- Amounts owed.This portion examines outstanding credit accounts and how much is owed on each obligation. This makes up 30 percent of the score. It’s called utilization and it’s now essential to maintaining a high credit score.
- Length of credit history.This portion reviews how long the applicant has used credit. Generally, a longer credit history leads to a higher FICO score. This makes up 15 percent of the score.
- Credit mix.This portion looks at the different types of credit given (e.g. retail store accounts, auto loans, mortgage loans). This makes up 10 percent of the score.
- New credit.This portion reviews how many accounts were recently opened, triggering a potential credit risk if a borrower opens “too many” lines of credit. This makes up 10 percent of the score.
All of these are important, but number 2 above-also referred to as credit utilization-is the newest and most important factor in your credit score and your daily life. Here’s why.
Perfect Payers Don’t Have Perfect Scores
In the past, if you had a steady income and always paid your bills on time, you were rewarded with a higher credit score-even if you had an unhealthy debt burden.
Not so today. Outstanding debt is now a huge part in a FICO calculation-and that is why many of today’s so-called “perfect payers” are ending up with diminishing FICO scores. These utilization rates are the central component to rewarding perfect payers with perfect scores.