First things first, you have to understand what's on your credit report and what goes into the calculation of your actual credit score. The true formula used in the calculation of the score is a bit of a secret, but according to the Fair Isaac Corporation, the evil (or genius) creators of the FICO score, the five key factors are payment history (35 percent), amounts owed (30 percent), length of credit history (15 percent), new credit (10 percent) and types of credit used (10 percent).
The first thing lenders look at is if you've paid your past credit accounts on time. Making payments to creditors on time is the silver bullet, but you have to pay attention to who is reporting on time payments to the credit bureaus. Many credit-reporting agencies don't report those items that are on time but they do report delinquencies. The length and severity of delinquencies is also said to be considered, so be mindful of that. Make a list of your creditors and identify the ones that report to the credit bureau. This will give you an awareness of which payments you're currently making that have an impact on your credit score and that ones don't.
The next most important component is the balance owed on your accounts, as it is 30 percent of the overall FICO score. Lenders look at how much of the total credit line is being used and other "revolving" credit accounts that one may have. That's essentially how much of a person's available credit he or she is using. If that person is trying to protect or increase his or her credit score that person should make sure he or she isn't using the full credit limit available. Sticking with half of one's available credit is a good rule of thumb. Creditors generally report to the credit bureaus once per month, so even if you're paying off the balance every month, but you're maxed out it could be used against you.
In the eyes of the lender small balances without missing a payment shows that you have managed credit responsibly, and for many that's better than no balance at all. So, for all those people who close credit cards thinking that helps increase the overall credit score, think again. This typically means there are now zero accounts in good standing and that's not going to raise your FICO store. Think of your credit report like your high school transcript for a minute. If you had a low grade point average what was the best way to improve it – get some better grades. Your credit report is the same way. You need to find some easy "A's" that will increase your overall credit score. Secured credit cards for some are easy A's if managed strategically, but that's another article.
Fifteen percent of the score is the length of credit history. The score takes into consideration how long credit accounts have been open, the age of the oldest account, the newest and everything in between. When it comes to your credit, old age and experience is a good thing and the longer the credit history the better. Your FICO calculation looks at the amount of outstanding credit you have available, the length of your credit history, as well as the percentage of credit used. Closing older, less frequently used credit cards may be a big no-no, and can hurt your score by decreasing the length of history, as well as increasing the percentage of your total credit.
Research suggests that opening several new accounts at once indicates a greater level of risk. New credit, which is one of the factors used in calculating the score, includes number of recent account inquiries, and number of new accounts opened. So, if you're asked at checkout to save X percent by applying for a card just say no. In most cases the inquiry will cost you more than what you've saved on the discount. When a lender checks your credit history as you apply for a new account, your score may drop by a few points – usually around five or less. To avoid lowering your score when you need a loan, condense the shopping period into a 30-day window.
Last but not least, your score considers the type of credit that is in use. This is where the whole good debt bad debt conversation comes into play. I have learned through trial and error that debt is debt. The only kind of good debt for me is when someone owes me money. That being said, mortgages, auto loans, and student loans are said to be considered "good" kinds of debt by lenders, so the score considers your mix of all the credit that has been extended to you.
Good credit is easy to get but takes discipline to maintain and sometimes a string of focus and luck. When bad credit hits, it's typically because life got in the way along the journey. No matter what the situation, understanding what goes into one's score is helpful to keep things great or turn things around if you've hit a roadblock. It's possible to have good credit until something happens like a job loss or loss of income and then things can take a turn for the worse very quickly. You're too blessed to be stressed over something you can work on. Order a copy of your credit report for free from www.annualcreditreport.com, dispute the negative items that can be legitimately disputed and start focus on rebuilding. It's a marathon not a sprint.
Nneka Serwaa Morgan is an investment professional with more than 10 years of experience. Her portfolio includes advisement to high-net-worth individuals, charitable donors and philanthropic organizations. Serwaaa Morgan is a frequent radio personality and newspaper columnist on topics of financial planning, investment management, and wealth creation. In 2007, she was named one of Ebony Magazine's "30 Young Leaders Under 30."