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Credit Scores 101: What They Are, How They're Calculated & Why You Need Them

February 23, 2018

On the surface, a credit score looks like a simple 3-digit number between 350 and 800. But it packs a powerful punch in determining your financial destiny, such as whether or not you get the loan or credit card you want at an interest rate you can afford. Beyond banks, others check your credit scores, too, to help decide if you get approved to rent an apartment, for an insurance policy or even for a job.

The reason your credit score has so much power is because it’s actually a complex, cumulative calculation that crunches the data from your credit report and compares your historical financial activity against others’ to determine your creditworthiness.

The higher your score, the more likely it is that you will qualify for loans, cards, and more at competitive rates. Conversely, the lower the score, the less likely it is that you’ll be extended credit, and even if you do qualify, you’ll likely be looking at very high interest rates. (There are, however, solid ways to start building credit when you have none, such as making sure your rent payments count.)

According to Equifax, the main factors on your credit report that are taken into consideration when calculating your score are as follows:

Your Payment History - 35% of Your Credit Score

This shows your financial habits over time, including if you’ve repaid debt you owe and are in the habit of paying bills on-time or late. This history also includes any public records and collections information, such as bankruptcies, liens, or other negative actions.

Your Credit Utilization Ratio - 30% of Your Credit Score

This mainly applies to your revolving accounts, like credit cards, where you have a credit limit and must pay down your debt at least at a minimum amount monthly. High credit utilization, which measures your available credit vs. used credit, is a warning signal because it shows lenders that you may already owe more than you can afford to pay back.

The Types of Accounts You Have, Otherwise Known as Tradelines - 15% of Your Credit Score

This includes revolving accounts, installment loans (like a car payment or mortgage) and “open accounts,” where fixed rate is due in full on a monthly basis. A healthy mix is a positive indication of how responsible you are with a variety of credit types.

New Credit Requests - 10-12% of Your Credit Score

This compares how many new credit accounts you’ve applied for compared with the total number of tradelines on your credit report. Your credit score takes into account how many recent requests for credit you have initiated. The more requests for new credit, which happen when you’re actually applying for a credit card or loan (known in the industry as a “hard pull,”) the worse it is for your overall score. (One important distinction: a “soft pull,” where a creditor asks to see your credit score or file for a preapproved offer or just to look at your existing account with them, or when you request a copy of your credit report, does not impact your credit score.)

The Length of Your Credit History - 5-7% of Your Credit Score

The longer you have accounts open in good standing, the better.

All of this information from your credit report is then run through a scoring model to determine your credit score. While there are many credit scoring models, the two most often used by lenders are the FICO Score, which was first developed by Fair, Isaac & Company in 1956, and VantageScore, created jointly by the three main credit bureaus — Experian, Equifax and TransUnion — in 2006.

Each scoring model uses its own secret formula to predict the likelihood that you’ll pay back a loan or credit card as agreed. There are several differences between the two models, according to NerdWallet, notably:

How paid off collections are treated: VantageScore disregards them, FICO keeps them in consideration.

Use of “Alternative Data”: This includes tradelines that have recently been included in the credit report mix, like utility and rent payments, that demonstrate positive financial action. VantageScore includes them in scores; FICO is currently pilot testing alternative data in the context of a more up-to-date scoring model.

How long a person has to have credit in order to get a score: VantageScore can generate a score after 30 days; FICO requires six months.

When the last time a credit account was used: VantageScore will look back 24 months; FICO requires that at least one account was used in the last six months.

Because scoring models are different, credit scores will vary, too. There are also several other reasons your scores might be different at each of the three main credit bureaus. Not all lenders and creditors report to all bureaus, and also each score may be from a different date.

While credit scoring is a complex business, the simple truth is that it reflects your financial habits. Take steps to give your credit score some love, and before you know it, you’ll be opening doors with your scores.