Financing

How Is Credit Score Calculated? + Strategies To Improve Credit

Why is it important to have a good credit score?

Poor credit can affect the ability to be approved for a mortgage, qualify for lower interest rates, and even being approved for a cell-phone plan. By understanding how credit works, you can reduce their risk of damaging their credit history or attaining a poor credit score.

Understanding and managing credit scores is a key financial skill beneficial for everyone to learn before they transition into the working economy, and even after doing so.

Yet, outside of economics and business majors, the vast majority of people receive little to no training whatsoever on the topic, which is highly unfortunate as it likely costs them a mountain of money down the road or even delays their future goals as wage earners.

Everything in the world is assigned a number: whether it is an address associated with a building, or the distance from the Earth to the sun.

People are no exception.

From birth, every baby born in the United States is assigned a Social Security number, just as every baby born in Canada is assigned a Social Insurance Number, and in Alberta, an Alberta Health Care Number.

When it comes to finances, people are also given a number.

This number is called a credit score. It is also known as a FICO score, an acronym for the Fair Isaac Corporation, a software known for calculating credit scores.

A good credit score helps students pay less interest on their debt and aids them in future big ticket purchases, like a car or a home.

Your credit score is just one part, or measure of, your financial history.

By knowing what credit is, understanding how a credit score is calculated, and knowing how to establish and maintain great credit, one can achieve a great credit rating and pave the road to financial freedom.

While monitoring one’s personal credit report each month may seem tedious, it is the first step in achieving better financial health.

How is Credit Score Determined?

One of the biggest mysteries regarding credit is how the credit score is generated.

Educating one’s self on credit can reduce the possibility of making simple yet significant financial mistakes.

A credit score, or FICO score created by the Fair Issac Corporation, is a generalized mathematical measure of how well an individual handles money loaned to him.

It is a complicated formula, but in short is measured by his or her credit history and how well loans are paid back.

FICO doesn’t hand out the exact formula, but they do tell us that the score is based on 35% payment history, 30% amounts owed, 15% length of credit history, 10% new credit and 10% types of credit a person has used.

Payment history: This also includes whether a person makes their payments on time and in full, bankruptcy, and accounts sent to collections.

Amounts owed: Means how much you owe versus how much credit you have, and you want as low a credit utilizations score as possible because lenders like to see you are far from maxing out your credit.

Length of credit history: The longer your credit history, especially with the same cards or loans, the better your score.

New credit: If you have a lot of new credit lines, this will slightly hurt your score. Credit inquiries can also cause your score to dip and include include anytime someone’s credit is pulled for things like cell phones, mortgages, and credit cards.

Types of credit: Lenders like to see a variety of credit used, so having more types of credit used successfully helps your score. The number and types of accounts that affect credit score include both open and closed accounts, how long they have been open, and if they are open, revolving, or installment accounts.

There are three elements to credit: a credit score, credit report, and credit history. Although they paint a similar picture, they are not the same.

Credit history is a record of a person’s financial background including payment history, open and closed accounts, and credit inquiries.

A credit report is where current financial information, like account balances, is found.

A credit score is a numerical calculation that represents someone’s risk factor in regards to their credit worthiness. Often, people do not realize the importance of having good credit.

There are three major agencies that keep track of all income earning citizens’ credit history: Equifax, Experian and TransUnion.

These companies compile data on how well credit is managed and report a score ranging from 300-850. The average of these scores is what is reported as your FICO credit score.

What is a good credit score?

The range of scores is categorized as follows: bad, fair, good, very good and excellent.

A score below 580 is considered bad and will result in a rejection from almost every loan. In the range between 580 and 669 is fair, 670-739 is good, 740-799 is very good and above 800 is exceptional.

Credit Score Range 
580 & BelowBad
580-699Fair
670-739Good
740-799Very Good
800Exceptional

A solid goal for all credit card holders is to reach and stay within the very good or excellent range.

This allows you to save more money and qualify for greater loans.

For example, on a loan of $200,000 paid back over 30 years, a typical house payment plan, individuals with a very good credit score qualify for loans with an interest rate around 3% whereas those in the good range qualify for loans at 3.5% interest

(Note: the interest rate numbers were rounded to make the math easier and do not reflect the actual values in any way, they are used as pure conjecture and hypothetical example).

Using the formula for simple interest, A = P(1+rt), we find that individuals in the very good category pay $180,000 in interest while those in the good category pay $210,000.

That is a huge $30,000 in savings, which is equivalent to the average price of a new car.

If there is one thing that kids should be taught in school, and are usually not, unfortunately, it is how to manage their finances. There is almost nothing, of value, one can acquire without good finance management and good credit.

The value of having a high credit score is made readily apparent and therefore it is important to understand.

How to Increase Credit Score

As they say, the best time to plant a tree was 20 years ago, and the second best time is today. If you start building your credit as soon as possible, in the future you can buy home and other large items more quickly.

What are the best strategies to build your credit and improve your credit score to reach the excellent range?

  1. Apply for more lines of credit:

    You can do this by applying for a business loan, student loan, any type of loan, finance a piece of equipment, apply for a few credit cards or any other type of credit.

    The most important thing to remember is to never apply for a credit line you can’t immediately pay back on time each month. Don’t miss a payment. In the case a full payment is not achievable, then a partial payment is better than no payment.

    Apply for as few credit lines as possible until you get a handle on paying them off. Unpaid credit is bad for your score, and every extra credit inquiry knocks points off a credit score temporarily.

  2. Keep accounts open:

    If you get a new credit card, pay off the old card but leave it open. Long term accounts benefit one’s credit rating.

  3. Lower Your Credit Utilization Score:

    You can do this by either increasing your credit limit on cards and then spending the same or less each month. Or, you can simply spend less each month to lower your credit utilization score.

  4. Pay off old debts:

    Pay off as many old debts as you can to lower your debt to income ratio and improve your credit score. Having less debt and more income is also good for your credit.

  5. Lean on someone else’s credit:

    Especially if you are young or just starting to build your credit you can start building your own with someone else’s help.

    Become a joint account holder and begin adding information towards your credit history. When you become a joint holder you will gain the other person’s credit history. When looking to become a joint holder, make sure to choose wisely on who you would like to lean on, you do not want a negative credit score.

  6. Use a secured credit card:

    This requires a deposit to obtain one. Once you receive the card you must put money on the card, and this way you can start building credit on your own name. After you have responsibly used the secured card for a full year, usually the company will return your deposit. After considering the second option you may consider maybe going a different route with a gas card, and this allows you to use fuel as leverage in gaining credit. You must either pay the gas card on time or on a regular basis so you do not get behind on payments.

  7. Take out a personal loan:

    After you have been building your credit for a while consider taking out a personal loan. Personal loans usually take about six to twelve months to increase your credit score. Using personal loans shows a diverse of ways you have raised your credit score. It also provides proof that you can pay your payments on time.

Following these rules along with monitoring one’s credit through an official credit bureau will improve the chances of having a great credit score.

Though there are many factors to one’s credit score, some are more important to remember.

Do not try to open too many accounts at once, pay debts off as quickly as possible, and always pay bills in full and on time. If you follow these rules, you will likely increase your credit score as time goes by.

If a person is struggling financially, they can still improve or maintain their score. The first step is to pay off any debts and consider getting a secure credit card. Being an adult is hard, but with a good understanding and the right tools, financial freedom is attainable.

Although it doesn’t feel like it, the late fees act as an incentive for you to pay your dues on time and it’s the credit card companies’ way of helping you build up your score. Some companies even allow you to set-up an auto pay option which helps build up or maintain your score if you are a somewhat forgetful person.

Some more advanced ways to improve your score include increasing the credit limit on your card, but keeping the ratio between your limit and how much you spend low, thus showing that you are a controlled and not impulsive buyer.

Another beneficial strategy to build credit is to manage two cards at once.

For example, if you are subscribed to something you can set that subscription payment on a second credit card and set up an auto payment plan on that card that just cycles through the subscription payment. This allows you to passively build up credit without much effort, but be careful not to overdo it as opening new lines of credit actually harm your score in the short term.

Additionally, be aware it takes a month or even up to 45 days for your credit score to update so progress will often be slow and steady.

Finally, as mentioned earlier, you can also build credit by paying off loans, albeit this is a doubled edged sword.

In the short term, a loan will always negatively impact your credit score, hence why in general it is not a good idea to take out multiple loans at once, but over time it can serve as an example for creditors of how well you handle repaying loans granted you do so well.

Unfortunately for college students, student loan debt will always negatively impact your credit score until you begin paying it down, however other debts like rent on an apartment can be used to supplement your credit history especially if you can show you made payments on time.

Overall, managing your credit is an essential financial skill to possess while on the road of life.

Tools to help improve your credit score

To stay on top of your finances, there are a few tools you cannot live without. Find the tools that work the best for you and make sure you use them regularly.

Some great ones are your planner, Outlook calendar, Excel spreadsheets, and of course your handy calculator.

The calculator can even be the built-in one on your phone. No need for super fancy tools in the majority of cases.

Once you have your bills under control, you can focus on raising your credit score, while also looking into the best investment opportunities that fit your life.

Examples of People Who Have Improved their Credit Scores

One example, Heather, has followed this advice and has already, in 8 short months, raised her score from a disgraceful 492 (mostly old hospital bills and an AT&T contract) and is now sitting at a 583.

I know what you’re probably thinking, yes, that is still extremely low but, in another 8 months well, the sky is the limit now a days.

Education is such a powerful tool and between God and a growing knowledge, today this once lost, scared, and discouraged young woman is now informed, confident, and excited to wake each morning to be all that she can be.

Another example, Brian, has an interesting credit story:

Brian is thirty years old and married with two children, as well as an adopted seventeen-year-old on the way, a house, and a credit limit of $20,000.

He makes roughly $19 dollars an hour after commission. He credits his financial success to hard work, overtime, and especially, good credit. Many of his friends and even wife either have bad credit or no credit at all.

When he was seventeen, his father made him save up $500 to purchase a secured credit card that he paid off each month.

After a few years, he branched out to other credit cards with higher limits and better rewards that paid him for spending money and then he paid them off each month accruing no interest. After thirteen years, Brian has racked up a $20,000 credit limit and maintained a $3,000 revolving credit balance because that is what he makes each month.

To put things simply, he lives within his means and uses his good credit to make credit cards work for him. This available credit has been invaluable to him over the years as emergencies have come up that would have severely crippled my finances had I not had good credit to fall back on.

For example, when baseball size hail damaged my roof bad enough to allow rainwater to leak into the house and ruin the laminate floors in two separate rooms, our insurance company refused to cover the sum of the damage.

Luckily, Brian was able to put the remaining repairs on a credit card. Too many people max their credit out and realize their mistake too late to prepare for an emergency.

This is not to say that my credit building history was without flaw. In his early twenties, he built up a sizable $15,000 dollars in credit card debt within a year. He had maxed out every penny of credit that I had.

That was then proceeded by seven years of paying this burden of stress off while still having emergencies, i.e. car problems, crop up occasionally. This was a lesson that he learned the difficult way and has already begun teaching his young children about counting money and the responsibility that comes with its use.

His wife accuses him of being too “far-sighted” all the time. However, his goal is to become fifty-five and retire, the two of them will be more than happy to travel the world debt free and stress free.

In the age of credit where everyone attempts to live outside their means, it’s more important than ever to remember that those who live responsibly will be rewarded in the long run.

It’s far too easy to swipe a plastic card that allows instant gratification to your every whim. In the end, there will be those forced to work well into their seventies because they have acquired such massive amounts of debt and those that have lived meek lives and retire at the age of their choosing.

Special thanks to Lyndsie McLeod, Abish Pius, SavannahLoehr, Brian Williams, and Heather Thurmand for their contributions to this article.

Let us know in the comments what strategies to improve your credit have worked for you.

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