Using your credit score in life off and on is an inevitable choice. Timely and inexpensive credit largely contributes towards streamlining your finances. You can not afford a credit denial at a critical stage in life throwing everything into chaos. Lending institutions use your credit score to evaluate your credit worthiness. Hence your best option is to have a good credit score on your records and keep improving it from time to time.
Without a good grasp of the mechanics though, you are bound to fail. Let us take a good look at this often ignored figure.
Although there is a host of scores used by credit lending industry, the FICO Score remains the industry-accepted benchmark. Hence we will focus our discussion on FICO. FICO was developed by Fair Isaac Corporation. Today it is the key method employed by lending institutions to facilitate the decision of extending or denying the credit to a client. So exactly how is the FICO calculated?
FICO picks 5 parameters from your credit records and assigns weight to them to calculate a resulting number, the FICO score. The parameters and their weights are: payment history (35%), credit exposure/utilization value (30%), duration of credit history (15%), fresh credit pattern (10%), and credit exposure types (10%).
You may already have started getting a fair idea of how the algorithm works. It doesn’t take a genius to figure out how the score is calculated and how you can improve it. Let’s take each element one by one.
Payment history
Your payment history is the key factor a credit lender is interested in. The creditor looks for the telltale signs of your ability to pay your credit obligations on time every time. The lender will not lend you the credit unless he thoroughly checks your history of payments.
If you are a prompt payer, you will increase your score and your chances to get more credit when you need it. Lapses and late payments count negatively towards the score.
Credit exposure Value:
FICO takes a close look at your credit limits and the utilization there against. It is done at both the individual and the aggregate level. A high credit limit manifests lender confidence in your credit worthiness. A lower utilization is seen as a sign of sound financial health. Hence if you have higher credit limits and a lower utilization (for example 30% or below in individual accounts), you will drastically improve your FICO.
Your best bet is to get as high a credit limit as possible and utilize the available limits only when extremely necessary for both individual as well as aggregate credit.
Duration of credit history:
Long and well-managed credit history sends the right signals to potential lenders about your credit worthiness. If your credit history is short-lived or mismanaged, the lender will have difficulty in assessing the credit risk and hence a possible lending aversion may take place contributing negatively to your credit records. Hence you should maintain a stable and sustained credit relationship with your lenders.
Fresh credit:
Credit requests and utilizations which are low in number and are spread over a proper frequency always contribute positively towards your score and credit records. If you have many credit requests simultaneously, or you have had quick abrupt requests and approvals on your credit records, you will send negative signals to lenders about your credit management skills. Hence you should plan your credit needs well in advance, spread them over evenly, and avoid applying simultaneously to several lending institutions.
Type of credit exposure:
If you are exposed to more than one credit types and you are responsibly managing it, you will increase your credit score significantly. Your lender will see you as an intelligent credit manager if you can manage your credit cards and debit cards as responsibly as your auto loans and mortgages. Nothing works better than a well-managed and diversified credit portfolio.
Perseverance and patience is the key to a sustained credit score. It takes time to bring an improvement. If your score was marred by credit mishaps in the past, fret not. Leave the past behind and start working on your score today.