What is a Credit Score and How is it Calculated?
You may already be familiar with the concept of a credit score. It’s just a three-digit number, right? In reality, there’s much more that goes into a credit score than you might think. You may be surprised to learn that you don’t have just one credit score—your score can vary by as much as 100 points between different sources. Each score will depend on a number of factors, including the company providing your score, their credit scoring models, and the data on which your score is based.
What exactly is a credit score?
While a credit report tracks your payment history toward a credit card (among many other things), your credit score is a cumulative measure of your creditworthiness. It takes a number of factors into account, including:
- Your payment history
- The length of your credit history
- The number and type of credit accounts you have
- Your credit utilization rate, and more
It may seem like credit scores are designed to prevent you from getting the credit you want and deserve. However, there are many benefits to the credit scoring system. Credit scoring uses a fair system of measurement, so the same criteria applies to everyone. Standardized credit scores also allow people with less desirable credit to be given loans with different terms.
Let’s go over how your credit score is calculated, to how it’s used, to its impact on your financial well-being.
How is my credit score calculated?
Your credit score takes multiple factors into account, including:
- Payment history: Your payment history has the highest impact on your credit score. This reflects whether you’ve paid your past credit accounts on time, which helps lenders determine the risk involved in extending you a line of credit.
- Used credit vs. available credit (credit utilization rate): This shows the percentage of your available credit that you’ve used. A higher ratio may indicate that you are overextending yourself financially, which could pose a risk to lenders.
- Length of your credit history: Companies may look at how long you have had your lines of credit for and how old your accounts are. Generally, having a longer credit history will increase your score.
- Diversity of your credit: Your score may take into consideration the types of accounts you have, including credit cards, mortgage loans, and installment loans. While you don’t need one of each, more diversified credit may lead to a higher score.
- Application history: A history of opening several credit accounts over a short period of time may indicate a high risk for failing to repay loans.
And how your credit score is rated—from worst to best—depends upon what credit reporting agency you are using to generate your score. That being said, credit ratings generally fit into the following categories:
- Below 600: Very bad credit
- 600–650: Bad credit
- 650–700: Fair credit
- 700–750: Good credit
- Above 750: Excellent credit
If your credit score is less than ideal, don’t panic. We’ll discuss some ways you can help raise your credit score and keep it up there, too
How are credit scores used?
Generally, credit scores are used to determine your creditworthiness—the likelihood that you are financially responsible and will pay off all lines of credit on time. Credit scores aren’t just used by banks, either. Any institution that lends money or requires monthly payments may use your credit score to determine whether you are likely to miss or make late payments.
Credit scores can also be used to determine things like the interest rates a lender will assign to loans or how large of a deposit a landlord will require. Furthermore, the types of credit scores that different lenders use will sometimes vary based on their particular industries. Auto lenders, for example, may look for credit scoring models that place a higher value on auto loan payment history. All in all, borrowers with higher credit scores are generally approved more frequently, pay lower deposits, and are offered lower interest rates than those with lower scores.
What is a FICO Score?
The most widely used type of credit score—used by 90% of top lenders—is the FICO Score. Prior to the introduction of the FICO Scores, there were many different methods of calculating creditworthiness (some even based on gender, ethnicity, and political affiliation). Developed using statistical models by Fair, Isaac, and Company (now known as FICO) in 1989, FICO Scores were devised to standardize credit scores and help make credit decisions quicker and fairer.
FICO Scores are three-digit numbers that range from 300–850. Generally, having a FICO Score greater than 700 will allow you to qualify for a greater number of loans with lower interest rates. The same criteria (payment history, amounts owed, credit history length, credit mix, and new accounts) are used to determine your FICO Score as most other credit scores.
Know your credit score—it’s important!
Understanding your credit score—as well as what goes into it and how it’s calculated by different bureaus and lenders—is a big part of maintaining your financial well-being. If your score is less than ideal, it’s important to rip that bandage off and get to know where your credit stands. Being aware of your credit score is the first step toward making smart decisions when borrowing and paying back lines of credit.
Here at Personify Financial, we understand the value of knowing your credit score. That’s why we allow all our customers to access their FICO Scores for free.