Understanding Credit and How Credit Score is Calculated

Learning how a credit score is calculated can provide insight into how to fix or improve your credit score. Why do you need this info? Credit scores have become one of the most important tools lenders (and others) use to make decisions about whether to lend money to a person. Whether you want to buy a car, open a credit card, or even get insurance, your score may be used to determine just how creditworthy you are.

Unfortunately, lenders do not have intimate knowledge or a way to see into the future to know how well someone will pay their debts once they lend money. The belief is, then, that the way a person used credit in the past is a good indication of how they will use it in the future. That’s why your credit history does matter.

Where does this number come from, though? What impacts it? Several different credit score models are used, and there’s plenty of confusion about how credit scores are calculated. To help you, let’s break down a few key things.

• You have more than one score – yes, they all matter.
• Your score will vary from one credit bureau and source to another.
• The same basic factors, like making on time payments and the way you use your available credit, all influence these scores.

Credit Bureaus

A credit bureau is an organization that collects the credit history of borrowers over time. They do not lend money. The three main credit bureaus in the U.S. are TransUnion, Equifax, and Experian. These credit bureaus act as a resource for storing all of the information provided by your lenders.

For example, when you open a new loan, your credit reports with each credit bureau update to include the new credit account. The lenders will send updates to the agency about how you use credit, such as if you make payments on time and how much you owe. Not all of the creditors and lenders you have will report to all of the credit bureaus. This can impact your credit score as well.

A credit report is a tool used to gather and organize this information. Your credit report helps lenders see who is lending to you, how much you owe, your credit limit, and your credit mix. This information is updated based on what your lenders or credit card issuers report to the credit bureaus.

The Main Types of Credit Scores

There are more than one type of credit score out there, but the two main ones used today are FICO and VantageScore. Most of the time, when you seek out a loan with a lender, they will pull your score from one of these two organizations to determine whether or not they should lend to you. Credit scoring models differ, but they are all based on the same factors.

The higher your credit score is, the less risk you present to the lender. That means you are more likely to pay your bill on time and use credit wisely. Each of these credit scoring agencies develops a numerical number to represent your credit score based on the way you use credit. Each has a bit of a different weight on one factor or another. This range is typically between 300 and 850. Aim for higher – it means lower costs and better credit availability.

Let’s break down the most important factors in determining a person’s credit score based on what the credit reporting agencies use.

FICO ranks the following components as the most important:

• 35% of the credit score is dependent on your payment history.
• 30% of the credit score is based on the amount you owe.
• 15% of your credit score is impacted by your credit history or the way you used credit in the past.
• 10% of your credit score is the amount of new credit you have.
• 10% of your credit score is dependent on the types of credit you have.

That means when you need to work to improve your score, you need to focus heavily on these areas from the top down to see the most results.

Your Payment History

When you look at your credit report, payment history is one of the most important components of how your score is calculated. All three major credit bureaus provide this information. It is a list of all of the credit you have and whether or not you pay your credit card accounts – as well as auto loans and other reported credit.

Your payment history affects credit for one big reason. If you have a history of making payments on time with the loans you have, that means you may be likely to make on time payments for new loans.

The credit score models look at a few things in this area:

• Do you make payments on time? On time payments are one of the most important factors. Having a history of them helps you to have good credit scores.
• Do you have late payments in your credit history? Lenders report payments that are 30 days late or longer to the credit bureaus. This can hurt credit scores. The number of late payments as well as if you are 30 days, 60 days, or 90 days late, will impact your score. Also important is whether you are still late on these loans or if you have brought them current.

Keep in mind that late credit card payments and other loan payments can remain on your credit report for some time. The Fair Credit Reporting Act is a federal law that states that negative information on your credit report can remain there for up to 7 years. After that, the information will fall off. These negative marks on your credit report can continue to hurt you for up to that long, though the longer the time is from a late payment, the better.

The Amount You Owe

Another key factor impacting your credit score will be the amount you owe. This is called your credit usage. It is the second most important thing credit score modeling generally weighs when assigning your own credit scores. The credit bureaus look at several things here.

• How much do you owe? This is the amount of money you owe on credit accounts you have. It will be on your credit report.
• How many credit accounts do you have? Do you have a large number of credit cards, mortgage loans, auto loans, and other debts? When they calculate credit scores, this plays a role in determining what your rate is.

The other key factor that plays a big role in your credit score is your credit utilization ratio. This is the amount of credit card debt you have based on the amount of your credit limit. For example, you may have a credit card with a maximum credit limit of $1,000. Of that, you may have used $400. That means you still have $600 of available credit. The credit utilization ratio helps to show how much of your available credit is used in your current credit card balances.

To find out what your credit utilization ratio is, add up all of the credit card balances you have. Then, add up your total credit limits – the amount you can borrow up to on all of your credit cards. Then, divide the credit card balance number by the credit card limits. Multiple this by 100. It will give you a percentage.

The credit scoring model determines what percentage is best and how much this impacts your credit accounts. However, the lower the utilization ratios are, the more likely it is for you to have good credit scores.

What is a good number? The lower your financial obligations are – the amount of your credit card balances – the better. Credit scoring models often rank people with a credit utilization ratio of under 30% as being good. The best credit scores typically will have less than 10% of their available credit used.

There are several ways to improve this figure. For example, you can pay down your debt to help lower this utilization ratio. Dropping the amounts owed is a good thing. However, you can sometimes improve this figure by increasing the amount of available credit you have, such as by opening new credit accounts. Work to pay down your debts by looking for ways to save money. For example, you may qualify for EASY Wireless, a type of free phone and plan that could help you keep more money in your bank account to pay down those debts.

The Length of Your Credit History

The next factor that credit scoring models generally consider when ranking credit scores is the length of your credit history. When did you first establish a payment history with credit card issuers? Did you open auto loans in the past to start your history?

Lenders want to see that you have experience managing credit over a long period of time. That helps them see what happens when you borrow money and how you manage revolving debt or debt you continue to pay toward from month to month. A longer history is a good thing, and it can help to give you a score update as time goes on.

Credit scoring models look at things like:

• The oldest accounts you have – when were your first credit history accounts established?
• How many new credit cards do you have?
• What is the average age of all of your credit accounts?

To build a good credit score, then, you need time. There is no shortcut to overcoming the length of credit history factor when it comes to managing your credit. However, the longer the history of credit you have and the harder you work to keep making payments on time, the better.

Remember that negative comments can also remain on your credit score for up to seven years. As a result, it is very important that you maintain your financial obligations in a healthy way over time. Keep your accounts current.

Also, if you decide to close a credit card that has good standing, that will affect your credit accounts. For example, if you close the first credit card you opened 10 years ago because you do not use it, that means your oldest credit card is now used to establish your credit history. It’s always a good idea to leave credit card accounts open, especially your oldest account.

Your New Credit

The amount of new credit can also play a role in your credit score. For example, if you open one credit card account and then apply for two more, three credit bureaus will note that. Lenders may wonder why you are looking for so much credit at one time.

These notes are called inquiries. There are two types you should know about:

• Hard inquiries are those where you apply for a credit card, auto loan, mortgage loan, or any other type of credit account. Multiple hard inquiries will lower your score. Many experts recommend having no more than one hard inquiry every six months to limit the impact.
• Soft inquiries are those that occur when a lender checks your credit to determine if they want to offer a loan or other offer to you. You have not requested this. Soft inquiries are not the same as hard inquiries. They do not impact your credit score.

If you have numerous new accounts on your credit score, that could send a message to lenders that you’re desperate for credit, and they may be Leary about offering it to you. Hard inquiries will remain on your credit file for up to two years, though they have less of an impact over time.

The Types of Credit You Have

Another factor to consider is the type of credit accounts you have, called your credit mix. For example, your FICO credit score may be better if you have numerous types of loans on it. That could be a car loan, removing accounts with retailers, an individual account for your mortgage, or others. Retail accounts, auto lenders, and mortgage lenders are all a bit different. A good credit mix shows you have financial success across multiple types of credit.

What Is a Good Credit Score?

Different scores and scoring models will be available for you. What’s most important here is to know that a higher score is better. However, different scores mean different things to some lenders. For example, a car loan lender may offer you a loan even if you have a lower credit score, while a cashback credit card may require one that’s higher.

When looking at the FICO credit score model, you can use this chart to help you see where you stand:

• 300 to 579 – Poor Credit
• 580 to 669 – Fair Credit
• 670 to 739 – Good Credit
• 740 to 799 – Very Good Credit
• 800 to 850 – Exceptional Credit

Your credit score plays a big role in your financial success. In fact, your credit score affects many of the decisions made about you in your life, including:

• If a lender will offer you a loan
• If you qualify for a mortgage to buy a house
• The amount of your interest rate on any loan you obtain
• Your ability to qualify for some types of jobs
• How much you can borrow

Because it is such a valuable number, it is important to monitor and keep improving it.

Where Can You Find Your Credit Score?

Knowing how to improve it can be hard if you do not know your score. Unfortunately, it can be hard to find this information in some situations. However, there are a few things you can do to get some information.

Your credit card account lenders may provide it to you

If you already have a credit card account, log into your online account. There, you may be able to get your credit score. Some of these credit card issuers offer a free credit score and will keep it updated month to month for you. There should not be any charge for seeing this information. Often, it is a perk of the credit card.

Check your bank

Some banks and credit unions also provide their customers with their credit scores. You can find this information available to you by logging into your bank account. If it is not there, ask your bank or credit union if they offer this information. You do not want them to pull this information as that could create hard inquiries. Rather, you just want to know if they follow it and, if so if they can share it with you.

Mortgage lenders may offer it

If you have a mortgage loan, your lender may have information on your credit score on your account. Again, you do not want them to pull a new one to check your score, but they may provide it as a feature or benefit to having an account with them.

Free credit score tools

There are a range of organizations that offer your credit score to you free of charge. One of the most readily used in Credit Karma. Credit Sesame and NerdWallet are alternatives. Keep in mind that the credit score updated here may not be exactly right. However, there is no charge for using these tools, and they can offer some insight into where you stand right now.

Keep in mind some companies charge a fee for this service. You can pay the credit bureaus a fee to gain access to your credit score if you would like to. Other companies will charge a fee to you as well, often as a part of credit monitoring services. Credit monitoring is a tool that will allow you to check for changes on your credit file over time. Though this can be a monthly fee, it may not be beneficial to many people.

Check Your Credit Reports

You are entitled under federal law to one free credit report from each of the credit bureaus each year. You can access it at AnnualCreditReport.com. This allows you to get a copy of your TransUnion, Equifax, and Experian credit reports. This will show you a lot of information about all your accounts. This includes:

• Each of the accounts you have
• The amounts owed on each of your accounts
• The length of credit history you have
• Payment history – if you make payments on time
• The type of credit accounts you have

It also provides information about you, including your name and all names you go by, as well as your addresses and past addresses, your employer, and any other information available about you. All of this is on your free credit report, and it is critical to check it.

Look through this information to be sure all of the accounts are yours. You also want to check the length of your credit history you have to be sure that’s accurate. Verify your identity and address, too. If you see any mistakes here, especially on revolving accounts, payment history, or your identification, be sure to report that information to the three credit bureaus to have it removed.

What to Do Next to Meet Financial Success

Understanding how this process works and the scoring models used is helpful because it can provide you with insight into how to see improvement. Establishing a longer credit history is key, which means you have to open and start using your credit. If the length of your credit history is not your problem, but you are struggling with late payments or other factors, it may be time to consider a few ways to improve your credit.

One of the best things about credit history is that it can improve over time. It is an ever-changing figure. You just need to know how to do that. By working on a consistent basis to improve your credit, you are sure to be well on your way to achieving your financial goals and building financial stability.

We can help you to do that, too. You can read our next article called “How to Fix Your Credit” to find out what steps you can take to improve these figures. There are a range of tools and methods available to help you to work to improve all of these factors.