How Your Credit Score is Calculated and Why it Matters

Your credit score can be one of the most potent financial tools (or setbacks) you can have, but do you fully understand what goes into calculating it, or why it matters? Making a life-changing purchase like buying a home, leasing a car, or applying for a credit card, the three digits making up your credit score can play a major role in your financial future, for better or worse.

Let’s break down just how credit scores are calculated, what sort of things can influence it, and why it’s important to strive for the most optimal score you can for your long-term goals, and even everyday life in general.

Credit Scores: Defined

Credit scores are composed of three numbers that reflect someone’s likelihood to repay money over time, whether a loan, credit card or car lease. The FICO Score is the standard U.S. scoring model, going from 300 to 850 with the higher the score, the better. FICO Scores are utilized not just by lenders, but also some employers to try to determine a prospective employee’s financial responsibility.

Another model, VantageScore, which came out in 2006, is used somewhat like the FICO Score, but with Vantage Score, only a single score combined from Equifax, Experian, and TransUnion is used, whereas FICO offers scores derived from each credit bureau, resulting in three different scores.

No matter which model is used, if your credit score is on the low end, you can face financial barriers if wanting to apply for a loan, or even trying to rent an apartment.

Reasons Why Your Credit Score Matters

Your credit score is more than just three numbers, it can directly affect your financial health, goals, and where you feel you may deserve to be in life. As mentioned, both lenders and some employers weigh in your credit score (and credit report) to approve you for loans, credit cards, or during the hiring process. When it comes to insurance companies, many insurers across various states also use your credit score to determine your premiums.

However, depending on the credit reporting agency (CRA) providing your credit report, you score can vary quite a bit since creditors don’t necessarily refer to the same three CRAs, but the outcome is still basically the same: a low credit score can slash your options financially, limiting you to bad credit loan options, and increase costs across the board, which is why those three little digits can have such an impact.

What Goes Into Calculating My Credit Score?

FICO scores are based upon five factors, but how much does it affect your overall score? Here’s a breakdown of each different factor:

1. Payment History – 35%

This is at the top for a reason, because it’s the most important. Many lenders will want to see if you can consistently pay your bills and loan/credit card payments on time. This can become a problem very quickly if you miss even one payment, with some creditors reporting delinquencies well before the standard 30 days. Bankruptcies, foreclosures, or any public record can come into play here.

2. Amounts Owed – 30%

How much debt you currently have compared to your available credit is your utilization. The lower your utilization ratio, the better it is for you. For example, if your credit limit is $10,000 and $3,000 is in debt, 30% is your utilization. The goal is to try to keep utilization below 30% on all credit lines.

3. Length of Credit History – 15%

The oldest, newest, and average age of all your accounts can say a lot about you, and the longer you can maintain an account, the better you look. Keep older accounts open, even if you rarely use them since age can positively impact your score.

4. Credit Mix – 10%

Variety is the spice of life. That goes financially, too: credit cards, installment loans (mortgages, car payments) can mean a better FICO Score.

5. New Credit – 10%

Recent inquiries, like opening new accounts in a short span of time, can turn into a big red flag since every time you apply for new credit, it’s a hard inquiry, which (temporarily) causes your score to drop. A soft inquiry, such as checking your own score, has no effect on credit.

Credit Score Number Ranges

If you want to know where you stand financially and how potential lenders or creditors may gauge you, knowing your credit score can show you how “attractive” (or maybe not so much) you are to them.

Poor (Below 580)

Less than 580 tells lenders that you may pose a higher risk and it may get you declined for most credit, and if you are approved (typically predatory or secured cards), interest rates are extremely high.

Fair (580 – 669)

This range is still considered subprime, with approval for only some credit products, like cards with zero rewards, but again, with high interest rates and strict terms, although you may be approved for high interest car and home loans.

Good (670 – 739)

A more acceptable range to most lenders where you’ll likely qualify for prime cards and average interest loans with decent enough terms.

Very Good (740 – 799)

Here, you’re considered a reliable borrower and can get approved for nearly any card, as well as low interest loans, higher credit limits, and fast approvals.

Exceptional (800 – 850)

This range is the cream of the crop. Borrowers in this range are considered the lowest risk and reap exceptional terms, rates, and available perks from lenders.

The average FICO score in America (around 71%) falls into the “Good” range, however, even just a few points can make a massive difference when you’re trying to negotiate the best interest rates, or when applying for a loan.

Why Does My Credit Score Constantly Change?

If you’ve started to regularly check your credit score and notice that it seems to change or fluctuate on a regular basis, there’s no reason to be alarmed or sweat over it. This is completely normal when information changes on your report, which happens frequently. What’s important is to try to stay within your ideal credit range, not a specific “score”. Lenders (for the most part) are not solely focused on your credit score, but your overall credit history, employment/income and other assets you may have.

Rather than striving for a perfect score, try to set up a plan for dealing with the unexpected, such as an emergency savings account, in addition to repaying outstanding debts. It’s really about your financial health and a verifiable history of positive credit habits that can make all the difference on a lending decision’s outcome.

Ways to Increase Your Credit Score

First off, understand that increasing your credit score isn’t a mad dash to the finish line. It is a marathon. You just have to start. Here’s how:

Try Paying on Time, Every Time

If tying a string around your finger isn’t doing the trick to get you to remember when certain bills are due, try setting up a calendar reminder or autopay so that you’re less likely to miss a due date. This is the simplest thing you can do to avoid potential adverse effects on your credit, not to mention some companies offer discounts for using autopay.

Keep Credit Utilization Low

The goal is to chip away and pay down account balances across the board, or request credit limit increases without adding on any additional debt. This means having your balance at 30% of the credit limit, if not lower, on all of your accounts.

Avoid Applying for Too Much Credit Simultaneously

Too many inquiries can hurt your score. Why? Hard credit inquiries happen when a lender requests to take a look at your credit report if applying for a new line of credit and it stays on your report for two years (but no longer a factor after one year). If you want to apply for new credit, space out your applications by a minimum of three months.

Keep Older Accounts Open

Old accounts, even if unused, can help lengthen your credit history as well as boost the available amount of credit you have, which can improve your overall utilization rate which is something lenders like to see.

Dispute Errors

A study by the FTC shows that five percent of American consumers have at least one error on their credit report, such as accounts (sometimes fraudulently) you didn’t open, or accounts flagged as late or defaulted upon incorrectly. Dispute inaccuracies with the credit bureau that shows the error.

Final Thoughts: Improve Your Credit by Being Consistent

Like it or not, your credit score can have a huge impact on your financial future, but now that you have a better understanding of what goes into calculating it and why it matters. You have the knowledge of how to control it by consistently checking your report in addition to making every effort to pay all bills on time. It can seem daunting, but if you just take the first step, you’ll begin building a better financial tomorrow, one point at a time.