What is a credit score and how is it calculated?

What is a credit score and how is it calculated?

What is a Credit Score?

Your credit score is a three-digit number that potential lenders use to determine your creditworthiness. It’s designed to indicate how likely you are to repay a loan in a timely fashion. A higher score reflects a lower risk of delinquency and gives lenders the confidence they need to offer mortgages, car loans, lower interest rates and higher credit limits. It can also help with other matters, like qualifying for an apartment rental or getting utilities to your home without first having to pay a deposit.

How Is My Credit Score Calculated?

Credit bureaus like Equifax and TransUnion compile your borrowing history to create credit reports, which are then used to calculate your score. It’s very common to have a slight variation in credit scores – different bureaus have access to different account information, and there are multiple credit scoring models, each with its own unique algorithm for calculating your score.

The most common credit-scoring model, the FICO credit score, evaluates your credit-worthiness on a scale that ranges from 300 to 850. Your credit score is based on five essential factors: Payment History, Amounts Owed, Length of Credit History, New Credit, and Types of Credit Used. Each of these factors is weighted differently based on their perceived importance. The below percentages are estimated weight of importance.

how your credit score is calculated

Payment History (35% of credit score): This is determined by how timely you have been on past payments. If you have a history of paying in full and on time, your score will be higher.

Amounts Owed (30% of credit score): This is based on how much of your available credit is currently being used. If a high percentage of your available credit is already borrowed, then you might be considered overextended, which would lower your score.

Length of Credit History (15% of credit score): A longer history of credit is generally considered favorable. Older accounts indicate that you have more borrowing history and therefore more experience repaying loans.

New Credit (10% of credit score): If you have opened multiple new credit accounts over a short period of time–a few months, for example–potential lenders will perceive greater risk.

Types of Credit Used (10% of credit score): A borrower who has different types of credit is generally considered more dependable since they’ve shown that they’re capable of handling multiple payments each month.

By handling your accounts carefully and paying your bills on time, you can ensure that your credit score is at least above average. Great credit scores are obtained by having little-to-no debt and a diverse array of accounts that show a long history of stability. Be patient, stay vigilant and make sure to only take out loans that you can afford to pay back in a timely fashion. The great score that will result could open up many financial doors.