What is a credit score and how is it calculated?

‍TL;DR: A credit score is a three digit number that is used to represent how "good" you are with credit (eg. loans, credit cards). Financial institutions (like banks) use this number to determine whether or not to lend you money.

Credit scores are based on your payment history, amount owed, length of credit history, types of accounts, and recent credit history. Lenders, such as banks and credit card companies, look at this number to determine if you’re a good candidate for a loan or line of credit. 

A high credit score usually allows you to get lower interest rates which makes borrowing more affordable. A poor credit score suggests that your repayments have been slow or incomplete and can make it difficult to obtain credit or may result in higher interest rates and less favorable terms.

Credit scores are typically represented on a scale of 300 to 850, with higher scores indicating better creditworthiness and lower scores indicating a higher risk of payment failure (also known as default).

What is a credit score?

A credit score is one number that gives a lender a sense of how likely you are to repay debts or money that you have borrowed. 

A lender could look at all the pages of information in your credit history to understand your creditworthiness, but that would take a long time. That’s why they rely on a credit score which summarizes an entire credit history in one number that’s easy to interpret. The closer the number is to the maximum score of 850, the more certain the lender can be that they’ll be repaid. 

The most widely used credit score service is FICO, which is short for The Fair Isaac Corporation. Data from FICO shows that the national average credit score is 716.

A good credit score makes life easier. Major life purchases become smoother and less expensive with a higher score. Banks use it to determine if they’ll offer someone a mortgage. Credit card companies use it to decide if they’ll give a person an account and a line of credit. 

Many car insurance companies use credit scores when calculating the rate they’ll charge. Even landlords sometimes look at credit scores. A low number might mean they will not rent you a property. Or a low number might mean that they’ll require a larger security deposit, a co-signer, or advance rent payments.

How does my credit score impact me?

Your credit score is your ticket to play. Want a loan to finance a big purchase? You’ll need a good credit score. Want a reasonable mortgage rate so you can buy a home? A credit score is the way in.

A credit score can impact you in 7 key ways:

1. Ability to obtain credit: ‍

Lenders use credit scores to assess your creditworthiness and determine whether to approve a loan or credit application. 

2. Interest rates: 

Your credit score can impact the interest rates you are offered on credit products, such as loans or credit cards. 

3. Insurance premiums: 

Some insurance companies use credit scores to assess the risk of insuring an individual and determine the cost of insurance premiums. 

4. Employment: 

Some employers may request a credit report or credit score as part of a background check. 

5. Housing: 

Landlords may request a credit score as part of the rental application process. 

6. Utility services: 

Some utility companies, such as cable or phone providers, may request a credit score to assess the risk of providing services.

How is a credit score calculated?

A credit score calculation uses 5 factors. They are:

• Payment History

Has the borrower paid their bills on time? Late payments, missed payments, and defaults can negatively impact your credit score.

FICO Weight: 35%

• Amount Owed

What’s the amount of credit currently used relative to the credit limit? High credit utilization can indicate too much reliance on credit, but some credit use is needed to show that you can make the repayments.

FICO Weight: 30%

• Length of Credit History

The longer the credit history the better the score. The calculation uses the age of the newest account, the age of the oldest account, and an average age of all the accounts.

FICO Weight: 15%

• Credit Mix

A credit score rises when there are a variety of credit types. Examples include, loans, credit cards, retail accounts, and mortgages.

FICO Weight: 10%

• New Credit 

Each time a person applies for new credit their score falls slightly. Frequent credit applications are seen as an indication that the person is facing financial hardship.

FICO Weight: 10%

A credit score will fall about 5 points when a lender makes a “hard” inquiry for the purpose of assessing an application for goods or services. This is different from a “soft” inquiry which is what happens when someone checks their own credit score or a current lender makes a periodic review of an account.

What does my credit score mean?

A credit score is like a grade for your financial life. The number shows how long you’ve had credit, how you managed it, and how many kinds of accounts you have experience using.

Your credit score helps lenders decide if they can trust you. This is important because a good credit score is your ticket to some of the largest and most important purchases you’ll make in life. 

Most lenders separate credit score ranges into 4 slices:

• Excellent: 740 or higher

• Good: 700 - 739

• Fair: 630 - 699 

• Poor: 629 and below

A higher score can add up to serious savings over the long term. Let’s look at an example.

Imagine that you’re buying a home and need a mortgage. Your credit score is 670, which is “fair.” Today, that score might get you a 30-year fixed-rate mortgage rate of about 6.310%

In this case, your monthly payment on a $300,000 house, after putting down 20%, will be $1,487.

What happens when your credit score goes up to 740 and is “excellent”?

Now your 30-year fixed-rate mortgage rate might be 5.69%. This means that your monthly payment on the same house is $1,391.

The savings is even greater when you look at the total interest paid over the life of the mortgage. With a “fair” score you pay $295,355 in interest over the 30 years.

With an “excellent” score you’ll pay $260,918 in interest over the 30 years which is a total savings of $34,437.

Why do I have different credit scores?

The FICO score is the most frequently used credit score but it’s not the only one lenders use. Some use the VantageScore which the three major credit bureaus in the United States developed together. Those bureaus are Experian, TransUnion, and Equifax.

The VantageScore also uses a 300 to 850 scale. The factors VantageScore uses are similar to the ones FICO uses but there are some differences. The VantageScore credit scoring factors and weights are:

• Payment History: 40%
• Amount Owed: 34%
• Depth of Credit: 21%
• Recent Credit Applications: 5%

‍

Here, “depth of credit” means credit age and mix.

Like FICO, the higher the score, the more creditworthy you are. A VantageScore works faster than a FICO score. After a month or two of opening a credit account you can generate a VantageScore. This takes at least six months for FICO.

If you have a good FICO score, you will almost certainly have a good VantageScore.