How Your Credit Score is Calculated

Credit Score and Magnifying Glass for background

Your credit score is a three-digit number that can make or break your financial future. It represents your payment history and helps potential lenders predict your ability to make future payments.

Every time you use your credit card, miss a payment or go over your credit limit, the action is used in a formula to determine your credit score. Creditors look at your score to figure how likely you are to repay money they lend you. A credit score is their way to determine risk. If you have a high score, creditors see you as a low risk for default, and they will offer you a lower interest rate. While a credit score is most commonly used to determine the interest rate you will pay on loans, landlords, and insurance companies may also use your credit score.

Even though your credit score is very important in determining your financial well-being, many consumers see it as a bit of a mystery, as it is difficult to predict what your credit score will be and how you can change it. To further muddy the waters, the credit score you purchase from a credit reporting agency could be quite different from the score your lender is seeing.

According to a new report from the Consumer Financial Protection Bureau, lender’s scoring models rank nearly 20% of consumers in different credit categories, which means consumers cannot trust the credit score they purchase from credit agencies to be an accurate representation of the interest rate they will receive.

FICO and VantageScore are the two types of credit scores. Created by Fair Isaac, FICO is the oldest and most commonly used credit score. A FICO score ranges from 300 to 850. VantageScore, which was created about ten years ago by the three major credit bureaus, Experian, TransUnion and Equifax, is a score that ranges from 500 to 990.

FICO’s Formula

Payment History. 35% of your credit score is based on your payment history, which means making payments on time is the most important factor in your credit score. Lenders use payment behavior to predict your long-term financial behavior. Student and auto loans, mortgages and credit cards are all included in your payment history. To improve this section of your credit report, make sure you make every single payment on time, every month. If you have made late payments in the past, you can overcome this by making timely payments going forward.

Debt Utilization. 30% of your score is based on your debt-to-available-credit ratio. Credit cards and revolving lines of credit are most heavily weighted here, so it is a good idea to keep your credit card balances below 30% of your credit limit. If you max out your credit cards or maintain a balance that is close to your credit limit, creditors may think you cannot pay for the loans you already have. To improve this section of your credit report, pay more than your minimum each month and strive to pay off your debt as quickly as possible. If you do pay off a credit card, do not cancel it, as the available credit will boost your debt utilization.

Credit History Length. 15% of your score is based on how long each account has been open and the length of time since the account’s most recent action. This section takes years to build, and provides creditors with a better understanding of your lifetime borrowing behavior. If you are just starting out, find a good credit card and keep it open.

New Credit. 10% of your score is based on how many new accounts you have opened. If you open several new accounts in a short period of time, you can represent a greater risk, especially if you do not have a lengthy credit history. If you are just starting to build your credit, do not open new accounts too quickly, as new accounts lower your average account age, especially if you do not have other credit information.

Credit Mix. The final 10% of your credit score is determined by your mix of retail accounts, credit cards, finance company accounts, installment loans and mortgages. A good credit mix demonstrates you can handle a variety of credit types. However, it is not necessary to have all forms of credit, so you do not want to open accounts that you do not need. Credit mix is mostly important if you do not have very much other information on which to base a score.

FICO reports that the importance of each category depends on the individual. A person who has just started building credit will be scored differently than someone who has a long credit history.

VantageScore’s Formula

VantageScore uses many of the same factors as FICO but ranks them differently. The formula is determined by six categories: recent credit (30%), payment history (28%), debt utilization (23%), depth of credit (9%), balances (9%) and available credit (1%).