How Are Credit Scores Calculated?

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What’s in a Three-Digit Number: Understanding Your Credit Score

Buying a house is a much more complex process than buying clothes or paying for a meal at a restaurant. That probably comes as little surprise given the relative price difference. The cost of a new home is usually hundreds of thousands of dollars, not the kind of money that most people have on hand for such a purchase. Most homebuyers finance a new home purchase through a mortgage. A bank, credit union, or lending company will cover most of the cost with this loan, which you will repay in a certain time frame including interest.

You might imagine there are various criteria and requirements for securing a loan, especially one large enough to cover a real estate property. Lenders have their own set of rules and processes for deciding who gets a loan and on what terms. While different institutions have different rules, all of them want to know how likely it is that you’ll repay the loan in full. A potential lender wants to know if you’re a reliable borrower or creditworthy. This creditworthiness is usually represented by a three-digit number called a credit score or rating. Here we’ll explore what credit scores are and how they’re derived.

Reviewing Your Borrowing History

If you’ve ever interviewed for a job, you understand that a potential employer wants to review your history as an employee. Similarly, a potential lender has to make a decision about lending you money. While a hiring manager might verify your employment history by contacting former employers, a lender isn’t going to talk to every individual or institution that has lent you money. This three-digit score is a quick way for a lender to gauge the amount of risk involved in letting you borrow money. A higher score tells financers that there’s a better chance of you making all your payments on time until the loan is repaid. Having the right score can be crucial to getting the loan you need.

While a lower credit score may not prevent you from borrowing money, it will dictate the terms and conditions of your loan. Applicants with lower scores are usually charged higher interest rates. This means that over the life of the loan, you can spend much more money in terms of interest charges. Consider two applicants who have both been approved for a mortgage of $200,000 to be repaid monthly in 15 years. Let’s suppose one applicant has an excellent credit score and is approved for a loan with a 3% interest rate. If we do the math, that person can expect to pay approximately $1,400 each month for a total of nearly $249,000 over the term of the loan. 

Let’s say the other applicant doesn’t have as strong of a borrowing history and is approved for the same amount of money ($200,000) for double the interest rate at 6%. In the same time period, that applicant will pay almost $1,700 each month and over $303,000 with the same repayment schedule. That’s a difference of nearly $300 each month, and $54,000 total! You should know that employers, landlords, and utility companies also review your borrowing history. You could be rejected for a mortgage, an apartment, or even a job, especially if another applicant has a higher score.

Understanding Your Scores

The most commonly used scores are reported by the Fair Isaac Corporation, the organization that develops the rating models used to determine credit scores. When companies are reviewing your credit score, they’re checking one or more credit bureaus or reporting agencies that use FICO models based on the type of loan or debt under consideration. You may have heard of one or more of these agencies:

  • Equifax
  • Experian
  • TransUnion
  • Innovis

Not all loans are viewed the same by lenders. While an employer may be interested in your overall credit rating from one or more of these bureaus, a credit card company may look at a model based on credit card debt. A car dealership’s finance department offering auto loans may review models based on that type of debt. 

Checking the Numbers

As a borrower, you’re entitled to a free credit report from a bureau. This lets you know where you stand, especially if you plan to apply for a loan in the future. While each lender has proprietary criteria for approving and rejecting loans, most use FICO ranges to see where an applicant’s credit ranks: 

  • Excellent: 800 and above
  • Very Good: 740 to 799
  • Good: 670 to 739
  • Fair: 580 to 669
  • Poor: Below 579

The lowest and highest scores are 300 and 850. People with scores over 750 are viewed as low risk and are usually eligible for the most favorable loan terms. 

Calculating Your Scores

The exact formulas used by FICO and other scoring analytics companies are privileged information. What is known are the various factors that influence your scores:

  • Payment History: 35% of your score is based on consistently paying your bills on time. You can improve your scores over time by paying your bills regularly.
  • Credit Utilization: 30% of your score depends on the ratio between your current debt and your total available credit. For example, if you have several credit cards with a limit of $10,000, and your total balances are $1,000, you have a credit utilization of 10%. It’s recommended that you have a max utilization of 30%. The less overall credit you use, the better. Maxing out cards can lower your credit score.
  • Average Age of Accounts: Lenders want to see if you have a long history of managing credit successfully. 15% of your credit score is based on the average length of your accounts. This is why opening new accounts and closing old accounts lower your score, as both actions reduce the average age of accounts.
  • Types of Credit: 10% of your score is based on having a good mix of credit. Credit cards, auto loans, mortgages, and student loans are different types of debts. Lenders want to see how well you manage all your debts.
  • New Credit: New credit applications are responsible for 10% of your score. When you apply for credit, companies will do an inquiry on your history which can lower your score. If there are too many new credit applications in a short period, you can come across as desperate for new credit, suggesting money problems. 

Staying on Top of Your Credit

In addition to a free annual credit report, you can also subscribe to a credit monitoring service. Some banks and credit card providers offer free monitoring. Staying on top of your credit alerts you to fraudulent activity, identity theft, or delinquent accounts. If you’re planning to buy a home or car or request a loan to start a business, you don’t want to discover problems after your loan application is rejected or denied. 

Who knew that a credit score could have such implications on where you live and where you work? It’s important to know where you stand and recognize behaviors and practices that positively and negatively impact your rating. If you need to raise your credit scores, you can come up with a plan that includes small steps that result in big impacts. Contact us today to get started on improving your creditworthiness.