How Credit Scores Are Calculated

Credit scores are numerical representations of an individual's creditworthiness, used by lenders to assess the risk of extending credit. In the United States, the most widely used credit score model is the FICO Score, developed by the Fair Isaac Corporation. Other models, like VantageScore, also exist, but they follow similar principles. This article explains the key factors that determine how credit scores are calculated, focusing primarily on the FICO Score model, which ranges from 300 to 850.

Key Factors in Credit Score Calculation

Credit scores are calculated based on information in your credit report, which is compiled by the three major credit bureaus: Equifax, Experian, and TransUnion. The FICO Score model considers five main factors, each with a specific weight:

1. Payment History (35%)

Your payment history is the most significant factor in your credit score. It reflects whether you’ve paid your bills on time. Key aspects include:

• On-time payments

  : Consistently paying at least the minimum amount due by the due date boosts your score.

• Late payments

  : Payments 30, 60, or 90 days late can significantly lower your score. The longer the delay, the greater the impact.

• Missed payments or defaults

  : Bankruptcies, foreclosures, or accounts sent to collections can severely damage your score and remain on your credit report for seven to ten years.

Maintaining a flawless payment history is crucial for a high credit score.

2. Credit Utilization (30%)

Credit utilization measures how much of your available credit you’re using, expressed as a percentage. It’s calculated by dividing your total credit card balances by your total credit limits. For example, if you have a $1,000 balance on a card with a $5,000 limit, your utilization rate is 20%.

• Low utilization

  : Keeping your utilization below 30% is ideal. Lower is better, as it signals responsible credit management.

• High utilization

  : Maxing out cards or carrying high balances can hurt your score, even if you pay on time.

To optimize this factor, pay down balances and avoid overusing your credit lines.

3. Length of Credit History (15%)

This factor considers the age of your credit accounts, including:

• Age of oldest account

  : A longer credit history generally improves your score.

• Average age of all accounts

  : Opening multiple new accounts in a short period can lower the average age and slightly reduce your score.

• Age of newest account

  : New accounts may indicate increased credit activity, which can be a minor risk factor.

Keeping older accounts open, even if unused, can positively impact this category.

4. Types of Credit (10%)

The mix of credit accounts in your portfolio—such as credit cards, mortgages, auto loans, and student loans—affects your score. A diverse mix can demonstrate your ability to manage different types of credit. However:

• Don’t open unnecessary accounts

  : Applying for new credit just to diversify can backfire due to hard inquiries (see below).

• Focus on what you need

  : A healthy mix develops naturally over time.

This factor has a smaller impact but contributes to a well-rounded credit profile.

5. New Credit and Inquiries (10%)

This category evaluates how often you apply for new credit:

• Hard inquiries

  : When you apply for a loan or credit card, lenders perform a hard inquiry, which can lower your score by a few points. Multiple inquiries in a short period may signal financial distress.

• Soft inquiries

  : Checking your own credit or pre-qualification checks don’t affect your score.

• New accounts

  : Opening several accounts in a short time can be seen as risky behavior.

To minimize impact, limit applications for new credit and space them out when necessary.

Other Considerations

While the above factors are the primary drivers, other elements can influence your score:

• Public records

  : Bankruptcies, liens, or judgments can significantly lower your score.

• Credit report errors

  : Inaccurate information, such as incorrect late payments, can unfairly reduce your score. Regularly review your credit reports from all three bureaus at AnnualCreditReport.com to catch and dispute errors.

• Scoring model variations

  : Different models (e.g., FICO vs. VantageScore) or industry-specific scores (e.g., auto lending) may weigh factors differently.

Why Credit Scores Matter

A higher credit score can lead to better loan terms, lower interest rates, and higher credit limits, saving you money over time. Conversely, a low score may result in higher borrowing costs or difficulty securing credit. Understanding how scores are calculated empowers you to take steps to improve your credit health.

Tips to Improve Your Credit Score

1. Pay bills on time

   : Set up reminders or autopay to avoid late payments.

2. Reduce credit card balances

   : Aim to keep utilization below 30%.

3. Keep old accounts open

   : They contribute to a longer credit history.

4. Limit new credit applications

   : Apply only when necessary.

5. Monitor your credit

   : Use free tools or services to track your score and report.

Conclusion

Credit scores are a snapshot of your financial reliability, calculated using a weighted formula that emphasizes payment history, credit utilization, and other factors. By managing these elements responsibly, you can improve your score and unlock better financial opportunities. Regular monitoring and proactive habits are key to maintaining a strong credit profile.