How to navigate your credit report

Creditworthiness—or lack thereof—is the foundation of a family's financial life. Last month, we explored the importance of reviewing your credit reports. Now, it's time to learn how credit scores are calculated.

When you pull your reports from the three major credit agencies (Equifax, Experian and TransUnion), you can pay a fee to see your FICO score. Lenders and insurers use this number, which ranges between 300 and 850, to assess the risk of doing business with you. A higher score means you're considered at lower risk of defaulting. A lower score means lenders believe you're more likely to pay late, default or file an insurance claim. (Your score won't be the same at each agency, but they should be in the same general range. If one is significantly lower, carefully check that report for errors.)

How is this magic number calculated? According to Fair Isaac Corp., which invented the score in the 1950s, here's the breakdown:

Payment history is 35 percent of your score. Credit agencies are looking for a history of consistent, on-time bill payment. Those who have it get higher scores.

If you're a chronically late payer, have accounts sent to collections or miss payments, your score will be lower. The good news? If you used to pay late, but now pay on time, eventually your score will rise. The older the slip-up, the less the impact.

What if you pay bills on time but don't see them on your report? Frankly, some bills don't count. Utilities (think water, phone and internet service) aren't reported unless they're sent to collections, so paying on time doesn't help, but missing them hurts. What does count? Credit cards, installment loans (car, mortgage and personal) and any loans/payments involving a finance company.

The amount owed is 30 percent of your score. This part isn't as straightforward. What actually counts is your credit utilization ratio. Put simply, it's how close you are to your credit limit. For instance, if you owe $4,950 on a credit card with a $5,000 limit, that's a high credit utilization ratio. If you owe $1,000 on a $10,000 car loan, that's a low ratio.

Of course, all loans have high ratios when they're new, because a borrower hasn't starting paying the balance. Generally, credit agencies aren't as concerned with one-offs. They're looking for a pattern: lots of accounts with high ratios, which might indicate someone is overextended.

The length of your credit history is 15 percent of your score. The best credit is old credit. The longer you've used credit, the higher your score, which is why it generally rises with age. According to Experian's 2016 State of Credit Report, the Silent Generation (born in the mid-1920s to the mid-1940s) has the highest average score at 730, compared with 700 for baby boomers, 655 for Gen Xers and 634 for millennials.

This isn't good news for young folks starting out, but since it only accounts for 15 percent of the total, it's not a deal breaker. The only remedy is to use credit, responsibly, over time.

Credit mix is 10 percent of your score. Aim for a variety of accounts. Do you only have a credit card? Do you have credit cards and student loans? Do you have credit cards, a car loan and a mortgage? Agencies like history, and they like variety. Credit mix will significantly impact your score only if you have a short history and there isn't much diversity in your file.

New credit is 10 percent of your score. Opening a new account is considered a sign of risk, particularly if you open a lot of them in a short time. Every time you apply for credit, your FICO score can fall slightly—and stay lower for up to 12 months.

Why? When you apply for loans and credit cards, the bank pulls your credit report. This is called an inquiry, and the credit agencies keep track of how many are made and how often. Multiple inquiries in a short amount of time, about 30 days or fewer, won't hurt you. They'll count as one inquiry, because the agency assumes you're shopping for a mortgage or car loan. But multiple inquiries over several months will negatively impact your score.

Denise Trowbridge is a self-professed money geek who writes about personal finance, banking and insurance. Follow her on Twitter at @DeniseTrowbridg.