Understanding How Credit Scores Are Calculated

In today’s world, credit scores play a vital role in our financial lives. Whether you’re applying for a loan, renting an apartment, or even trying to get a new job, your credit score can greatly impact your opportunities. However, understanding how credit scores are calculated can often be a mysterious and confusing process. In this guide, we’ll explore the key factors that contribute to credit scores and their impact on financial health.

What is a Credit Score?

Before we dive into how credit scores are calculated, let’s review credit scores in general. A credit score is a three-digit number that provides a snapshot of an individual’s creditworthiness. It is calculated based on several factors, including payment history, credit utilization, length of credit history, new credit applications, and types of credit used.

Credit scores are commonly monitored and provided by major credit bureaus such as Equifax, Experian, and TransUnion, which play a significant role in assessing an individual’s credit health and determining their creditworthiness.

Understanding how credit scores work and the factors involved can help individuals make informed financial decisions and improve their credit standing. In this guide, we’ll explore the key factors that contribute to credit scores and their impact on financial well-being.

Why is a Credit Score Important?

A good credit score is crucial for multiple reasons. Firstly, it directly impacts your ability to obtain credit, as lenders use it to assess the risk of doing business with you. A higher credit score increases approval chances for loans and credit cards, offering better interest rates and terms. Conversely, a lower credit score may lead to higher interest rates or credit denial. Additionally, credit scores can influence non-financial aspects, such as evaluations by landlords, insurance companies, and employers regarding trustworthiness and reliability as a renter, policyholder, or employee.

LEARN MORE: 5 Helpful Tips for Understanding Your Credit Score

How a Credit Score is Calculated

The exact formula used by credit bureaus to calculate credit scores is proprietary and not publicly disclosed. However, a general framework and the key factors typically considered in credit scoring models are known. Keep in mind that different credit bureaus and financial institutions may use variations of this framework.

General Credit Score Formula

There are five weighted credit scoring factors that contribute to every credit score. They include:  

1. Payment History (35%)
2. Credit Utilization (30%)
3. Length of Credit History (15%)
4. New Credit (10%)
5. Types of Credit Used (10%)

In a later section, we’ll look at each of these factors in more detail, but simplifying knowing the factors and their weights is enough to illustrate how credit scores are calculated. With these in mind, a general formula for determining credit score would read like this:

Credit Score = (Payment History * Weight) + (Credit Utilization Ratio * Weight) + (Length of Credit History * Weight) + (New Credit Applications * Weight) + (Types of Credit * Weight)

Please note that the weights and specific factors can vary between different credit scoring models. Also, other factors, such as public records (bankruptcies, liens, judgments) and credit inquiries, may also be considered in some scoring models.

It’s important to remember that while the formula provides a general idea of how credit scores are calculated, credit scoring algorithms are complex and may incorporate additional factors or adjust their weightings over time. Additionally, credit bureaus may use their own variations of scoring models, so your credit score can vary slightly between different credit reporting agencies.

It’s also worth noting that paying off debts has an impact on your credit score, as well.

5 Factors that Determine Credit Score

Now, let’s explore the five key factors that influence them. Below, we’ll explain what each of these factors are and how they impact your credit score. 

Payment History (35%)

Payment history is the most significant credit score factor, reflecting timely repayment of debts like credit cards, loans, and mortgages. Consistent on-time payments demonstrate reliability and responsibility, positively impacting your score. Late or missed payments signal a higher risk of default, negatively affecting your credit. Other financial commitments, like utility bills and rent payments, may also be considered by lenders.

Impact of Payment History

• A strong payment history with consistent on-time payments is crucial for a favorable credit score.
• Late payments, collection accounts, or loan defaults can significantly damage your credit score and make it harder to obtain credit in the future.
• Lenders assess your payment history to determine your financial responsibility and reliability as a borrower.
• Consistently making on-time payments positively impacts your creditworthiness and increases approval chances for credit.
• Conversely, a history of late or missed payments may raise concerns for lenders, resulting in higher interest rates, stricter terms, or credit denials.

Credit Utilization (30%)

Another major factor for credit score is utilization. Credit utilization is the percentage of your total available credit that you are currently using. Lenders prefer a low credit utilization ratio as it indicates responsible borrowing and a lower risk of default. For example, if you have a credit limit of $10,000 and an outstanding balance of $2,000, your credit utilization ratio would be 20%, which is favorable to lenders. Maintaining a low credit utilization is essential, but avoiding credit use altogether can negatively impact your score. Striking a balance between responsible utilization and timely repayments is key.

Impact of Credit Utilization

• Maintaining a low credit utilization ratio demonstrates responsible credit management.
• Aim for a utilization ratio of less than 30% to maximize positive impact on your credit score.
• High credit utilization may raise concerns about overreliance on credit and lower your score.
• Keeping credit utilization low shows financial discipline and increases your creditworthiness to lenders.

Length of Credit History (15%)

Credit history length reflects how long you’ve been using credit and shows your financial track record. Lenders prefer borrowers with a longer credit history as it provides more data points for assessing creditworthiness and financial habits. For example, a ten-year credit history gives lenders ample information to evaluate payment patterns, credit utilization, and overall financial behavior, instilling confidence in responsible credit management. If you’re new to credit, lenders may view you as higher risk due to limited information. However, focus on building a positive credit history by making timely payments and using credit responsibly.

Impact of  Length of Credit History

• Longer credit history enables more accurate assessment of creditworthiness.
• Positive financial behaviors become evident over time, contributing to a higher credit score.
• Lenders have more data to evaluate financial habits and assess borrowing risk.
• Track record of stability and consistency boosts lender confidence and increases credit score.

New Credit (10%)

New credit accounts, like credit cards, are another factor in credit score. Be cautious when opening multiple credit accounts or applying for several loans in a short period. Lenders may view it as financial instability and could negatively affect your credit score. If you’re shopping for the best loan or credit card offer, multiple applications within a specific timeframe are usually treated as a single inquiry. Apply for new credit wisely, considering your financial capacity.

Impact of New Credit

• Multiple credit applications in a short period can lower your credit score due to hard inquiries.
• Limit credit applications to what is necessary to avoid negative effects.
• Hard inquiries signal you are actively seeking credit and may be viewed as higher risk.
• Opening many new accounts at once can raise concerns about managing multiple obligations.
• This can result in a negative impact on your credit score and make future credit approvals challenging.

Types of Credit Used (10%)

Finally, a diverse credit portfolio can boost your credit score by showcasing your ability to handle different types of credit like credit cards, loans, and mortgages. However, don’t pursue unnecessary credit. Focus on timely payments, low credit utilization, and building a positive credit history, as these are more impactful factors for managing your credit and securing favorable terms in the future.

Impact of Different Types of Credit

• Having a mix of credit types (credit cards, installment loans, mortgages) demonstrates your ability to handle diverse financial obligations.
• Only pursue necessary and suitable credit to avoid excessive debt or repayment difficulties.
• Lenders assess your creditworthiness based on a variety of credit accounts, so having a mix shows your ability to manage different types of debt.
• A diverse credit portfolio increases your creditworthiness and financial versatility.
• Avoid pursuing unnecessary credit to prevent negative consequences, like damaging your credit score or facing financial difficulties.
• Carefully consider your financial situation before applying for credit and prioritize repayment ability.

Final Thoughts

Understanding how credit scores are calculated is essential for anyone who wants to maintain or improve their creditworthiness. By understanding the factors that influence your credit score, you can take proactive steps to manage your financial behavior and make informed decisions when it comes to borrowing and using credit. Remember, a good credit score opens doors to better financial opportunities, so it’s worth investing time and effort to understand and improve it.

Calculating Credit Score FAQ

Below are some commonly asked questions about how credit scores are calculated and their answers.

Certainly! Here are five common FAQs about calculating credit scores and their answers:

How are credit scores calculated?

Credit scores are calculated using various factors, including payment history, credit utilization ratio, length of credit history, types of credit, and new credit applications. Each factor is assigned a weight, and a weighted sum of these factors is used to determine the credit score. The formula may vary depending on the credit scoring model used.

What is the most important factor in calculating credit scores?

The most important factor in calculating credit scores is typically the payment history. Timely payments on credit accounts demonstrate responsible financial behavior and have the most significant impact on credit scores.

How does credit utilization affect credit scores?

Credit utilization, which is the percentage of available credit you’re currently using, plays a crucial role in credit scoring. Keeping your credit utilization ratio low (ideally below 30%) positively impacts your score, as it shows responsible credit management.

Can closing old accounts improve credit scores?

Closing old accounts can potentially harm your credit score. Length of credit history is a factor, and closing old accounts shortens the average age of your credit accounts, which can lower your score. Additionally, closing accounts can also affect your credit utilization ratio if it reduces your total available credit.

How often do credit scores change?

Credit scores can change frequently, depending on your credit activity. Factors like new credit applications, missed payments, or changes in credit utilization can lead to score fluctuations. However, credit scores typically don’t change on a daily basis and might be updated every few weeks or months, depending on when lenders report data to credit bureaus.

Please note that credit scoring models and the weight assigned to each factor can vary between different credit bureaus and lenders, which may lead to slight variations in credit scores.

Alyssa Francisco

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