How is Your Credit Score Calculated?
If you are a home buyer who is seeking a mortgage, you will soon discover that your credit score plays a vital role in determining the interest rate that a lender offers you. That is why it is so important that you truly understand your credit score. In this article we will answer four important questions about credit scores: What is a credit score? How is your credit score calculated? What is a good credit score? and What are the most important parts of a credit history?
Question 1: What is a credit score?
A credit score is a number generated by a mathematical formula using information from your credit report that represents an estimate of your creditworthiness that lenders use to estimate risk. Lenders have learned through experience that borrowers with higher credit scores are more likely to pay off a loan. So, the higher your credit score, the better you look to lenders, the lower your interest rate will be.
Question 2: How is your credit score calculated?
Credit scores are calculated by plugging the data from your credit report into a mathematical formula. The resulting number is used as a prediction of how likely you are to pay your bills. Currently, each of the three major credit agencies use their own version of the scoring formula - Equifax has the BEACON score, Experian has the Experian/Fair Isaac Risk Model and TransUnion has the EMPIRICA score. So don't be surprised if you discover that the credit scores they each generate for you are different. Each credit agency is using a different formula in an attempt to come to the same conclusion.
Question 3: What is a good credit score?
In general, credit scores range between 300 and 850. The higher your credit score, the less likely a lender believes you will default on a loan. As a result, as your score increases, the interest rate you are offered usually declines.
Financing options and better interest rates are typically offered to borrowers with credit scores over 700. If your score is lower than this don't be discouraged. There is a mortgage product out there for nearly everyone.
Here's a look at how credit scores among the U.S. population currently break down:
It is likely that your bank will pull credit reports and scores from all three of the major credit reporting agencies: Equifax, Experian, and Transunion. Of the three scores, they will probably use the middle score for your loan application. Be sure to ask your lender to explain which credit scores will be used and how the credit scores being used will affect your loan application.
Question 4: What are the most important parts of a credit history?
The most important parts of a credit history include your payment history, your debt, your length of credit history, your types of credit used, and your new credit. Each aspect of your credit report contributes to a credit score calculation. The percentages listed below give a breakdown of the approximate value that each part of your credit report adds to your credit score calculation.
35% - Your Payment History includes the following:
1. The number of accounts you have paid as agreed.
2. Your negative public records and/or collections.
3. Your delinquent accounts such as the total number of past due items, how long you have been past due, and how long it has been since you've had a past due payment.
30% - Your Debt includes the following:
1. The amounts you still owe on installment loan accounts vs. their original balances - this is to make sure that you are paying them down consistently.
2. The number and types of accounts with negative balances you have and how much you owe on each.
3. The amount of your revolving credit lines that you have used - lenders are looking for indications that you may be over-extended.
4. The number of zero balance accounts you have.
15% - Length of Credit History includes the following:
1. The total length of time tracked by your credit report.
2. The length of time since the accounts were opened.
3. The amount of time that has passed since the last account activity.
4. It is important to note that the longer your good credit history, the better your credit scores will be.
10% - Types of Credit Used includes the following:
1. The types of accounts (installment, revolving, mortgage, etc.) and total number of accounts.
2. It is important to note that a variety of account types will more often generate better scores than will reports limited to only numerous revolving accounts such as credit cards.
10% - Your New Credit includes the following:
1. The number of recent inquiries to your credit history.
2. The amount of time that has passed since recent inquiries or newly-opened accounts.
3. The proportion of new accounts to total accounts and the number of accounts you have recently opened.
4. If, after encountering payment problems, you have re-established a positive credit history.
5. It is important to note here that lenders are checking to make sure that you are not attempting to open numerous new accounts.
While credit scoring formulas only consider items on your credit report, lenders will usually look at other factors that aren't included in the reports. These include your employment history, income, and the type of credit you are seeking.
Hopefully after reading How is Your Credit Score Calculated, you now have a better understanding of what your credit score is and why it is so important. Since a better credit score is going to lead to a lower interest rate loan, understanding how your credit score is calculated will give you the knowledge to help you save money.
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