How Are Credit Scores Calculated? - liveandloveoutloud.com

How Are Credit Scores Calculated?

Whether you were born in the U.S. or you move here, understanding how credit reports and credit scores work is an important part of your financial life. Your credit score plays an essential role in pretty much everything related to your personal finances.

Knowing what goes into your credit score and how it’s calculated can help empower you to make the decisions that will allow you to have a good score, and then you’ll have more financial opportunities as a result.

“Even if you’re just looking for a new job or apartment, having a thin credit profile—meaning you don’t have enough credit history to generate a credit score—can prevent you from beating out other applicants,” writes Ben Luthi of Remitly.

Whether you’re looking to establish yourself, or maybe re-establish yourself, the following are some key things to know about how scores are calculated.

The Role of Credit Bureaus

Credit bureaus are also called credit reporting agencies, and these organizations play a central role in the creation of credit reports. Credit bureaus have the responsibility of collecting information about credit behavior. Then, credit bureaus provide that information to lenders or the businesses or individuals who request it.

The three main credit bureaus in the U.S. are Equifax, Experian, and TransUnion.

Not all loans you might get are going to be reported to all three agencies, so that’s why your credit score might be different across different calculations.

Whenever you borrow money, whether that’s in the form of a mortgage, a car loan, or a credit card, the information about you obtaining that loan and how you pay it back are reported to bureaus.

Other information reported to credit bureaus include the amount due, the amount you’ve paid and whether your account is current, past due, or paid and closed.

Scoring Models

Just as there are different credit bureaus, there are also different models that are used to calculate credit scores. The most common scoring model is the FICO Score, but there’s also the VantageScore.

These scoring models range from 300 to 850, and each uses five factors in the model.

Payment History

Your payment history accounts for 35 percent of your total credit score. It’s the most important factor because it shows possible lenders whether or not they’d be taking too much of a risk by extending you credit.

If you’re making on-time payments and you regularly do, you’re more likely to be approved for more credit. However, payment history isn’t everything.

Amount of Debt

The amount of debt you have is the next most important factor beyond your credit history. It’s estimated to account for about 30 percent of a credit score.

If you have a credit card with a $10,000 limit, and you’ve used none of that, then it’s going to be very good for your score because you have a lot of available credit open to you. If you’ve used $9,000 of that $10,000, even if you’re making on-time payments your score is going to take a pretty significant hit.

This is described as your credit utilization ratio.

Credit Age

How long your accounts have been open and the average “age” of your credit account for around 15 percent of your score. Basically, the longer you’ve had different forms of credit available to you, the better in this area. Then, if you’ve had credit for longer periods of time and you’ve managed it well, even better.

New Credit and Credit Mix

There are two other concepts that are part of a credit score, and both makeup around 10 percent of it. The first is new credit and the second is the credit mix.

If you have a lot of new credit that was all opened close to each other, it can be problematic. The idea is that this could signal to lenders that you’re in some situation where you need access to a lot of credit. This could make them cautious to lend to you.

Opening new credit accounts also lower your average account age, which isn’t good for your score either.

Credit mix refers to the diversity of the types of credit you have on your report. For example, it’s good to have a nice, balanced mix of revolving and installment credit. Revolving credit is something like a credit card, while installment loans are something like a mortgage or a car payment where you pay a set amount each month.

Overall, having some understanding of these factors can help you as you work to build or rebuild your credit.