What exactly is credit? According to E. Garman and Raymond Forgue, authors of “Personal Finance,” credit is an arrangement in which goods, services or money is received in exchange for a promise to repay at a future date. The definition of credit is important before defining credit score.
Credit score, as defined by Garman and Forgue, is a statistical measure used to rate applicants based on various factors deemed relevant to creditworthiness and the likelihood of repayment.
A person’s credit score is a numerical value that will show lenders how dependable of a borrower someone is. This score is called a Fair Isaac Corporation (FICO) score. The score ranges from 300 to 850 — 300 being the worst and 850 being the best.
To help someone understand this better, here are the approximate credit score ranges: 800 and up is well above average, 740-799 is above average, 670-739 is the median, 580-669 is below average, and 579 and below is considered poor. Note, these are approximate values and can vary depending on the lenders and other financial companies. This score becomes important when someone wants to apply for vehicle loans, mortgages and credit cards because it will generally lead to lower interest rates.
So, how does an individual go about increasing and maintaining a good credit score? Here are the five factors used to determine what a person’s credit score is and how important each factor is.
Payment history (35 percent)
Payment history contributes 35 percent to the FICO score calculation. This is the largest and possibly most important factor that contributes to someone’s score. Payment history records whether a person is paying the minimum amount each month before a due date. If they fail to do this, it can negatively affect their credit score.
Amounts owed (30 percent)
Amounts owed contribute 30 percent to the FICO score calculation. If a person has a balance on any card more than 30 percent of their credit limit, it will negatively affect their FICO score. For example, if they have a credit limit of $5,000 it would be in their best interest to keep their balance below $1,500 as often as possible.
Length of credit history (15 percent)
Length of credit history accounts for 15 percent of the FICO score calculation. Generally, the longer someone has a credit history, the higher their score will be.
Taking on new credit (10 percent)
Taking on new credit accounts for 10 percent of the FICO score calculation.
Credit mix (10 percent)
Credit mix (credit cards, retail accounts, mortgages, installment loans, etc.) makes up the final 10 percent of the FICO score calculation. The last two factors that affect how a person’s FICO score is calculated can be mixed into one. The final 20 percent has to do with a person’s combined ability to take on more debt and have a good balance of credit. The more debt a person can responsibly handle will improve their score, as well as having a good mix of credit usage.
Caution — for people that may not fully grasp this concept, but want to either establish or raise their credit score, be sure to have a foundation of good money habits before continuing. If a person is irresponsible with their money and decides to try raise or establish their credit score, it could be far more harmful than beneficial in the long-run.
This information is to provide knowledge to people that may not understand credit, credit scores and how they are calculated. Whether a person has a high credit score, low credit score or no credit score history, it is still important to understand how it works. I encourage people to take this information and try to understand more information related to personal finance.
People should be skeptical and seek information related to money before acting to become more at peace with their financial life.
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