If you're applying for a car loan, a home mortgage, or a credit card to finance your next vacation, banks and other institutions will likely base their lending decision, at least in part, on your credit score. The higher the score (other things being equal), the more money lenders will offer and the lower the interest rate they'll charge. Credit scores are a relatively new invention. As credit cards became popular in the 1960s, card issuers needed a way to determine whether an applicant was likely to pay his or her bill on time. Although lenders used various means to assess that risk, their methods tended to be inconsistent and sometimes inaccurate. Around the same time, Congress started cracking down on discriminatory lending practices by passing several pieces of legislation that reined in lenders and collection agents.
All this didn't go unnoticed by a firm called Fair Isaac and Company. They developed a risk scoring model in the 1980s, a score that was widely adopted by credit issuers and banks throughout the United States. The FICO score was born. That score, which ranges from 300 to 800, is based on five factors that are considered good predictors of risk.
Payment history (35%). This factor is given the greatest weight. Lenders want to know how many bills you've paid late and how many were sent to collections. The more recent the problems, the greater the negative impact on your score.
Outstanding debt (30%). Rule of thumb: keep your credit card balances at 25% or less of their limits.
Length of time you've had credit (15%). In general, a longer credit history will generate a higher overall score.
New credit (10%). Opening several new accounts tends to impact your score negatively in the short term.
Types of credit (10%). Having experience with several types of credit — revolving credit, installment loans, mortgages — can push your score upward.
The FICO score isn't the only score used by lenders, nor is it the only factor they consider. In fact, some lenders may use a different scoring model altogether. Nevertheless, by keeping a watchful eye on the above five factors, you can certainly increase your odds of obtaining credit at reasonable interest rates. What's the best way to monitor your credit? Examine your credit report regularly and quickly resolve any inaccuracies.
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