How Credit Scores are Calculated

How Credit Scores are Calculated

Most young adults understand the general concept of a credit score and know that it is important. Unfortunately, not all schools put an emphasis on these concepts – leaving many adults at this level of understanding. 

We define credit as:

A measure of your trustworthiness and risk in the eyes of lenders. It helps determine your ability to borrow money or resources now and pay for them later or gradually over time.

Your credit score is simply putting a number to that measurement, which allows lenders, potential employers, and others to easily compare and make determinations based on your credit.

Before we dive into everything about credit scores and how they’re calculated, here’s a piece of advice: Try not to get too hung up on your specific score when it comes to monitoring your credit. Credit scores naturally fluctuate. Sometimes a drop in your score is expected and necessary. Focusing on the factors that affect your credit score and constantly trying to improve, regardless of your current standing, will help ensure long-term credit health.

Types of Credit Scores

There are several different credit scoring models, each with distinct characteristics. The three major national credit bureaus are:

  • TransUnion
  • Equifax
  • Experian

There are many other credit scoring models and variations on each, however. Most lenders will use the FICO scoring model for determining credit approvals.

It may seem like there are too many variations to ever truly know what your score is, but there’s no need to worry. While there might be slight differences in your specific credit score from day to day or according to different scoring models, the principles that guide them are consistent and the general health of your credit will be the same.

Credit Score Calculations

There are five primary factors that determine your credit score. The general importance of each factor is consistent across scoring models. Here is FICO’s take on the credit score breakdown.

Basic Credit Score Formula

Credit Score FactorImpact
Payment History35%
Credit Utilization30%
Credit Age15%
Credit Mix10%
New Credit10%

Payment History: 35%

The most important factor of your credit is payment history – your ability to repay debt. This of course makes sense, a lender wants to be certain that they will be repaid. If you’re trying to raise your credit score, or simply maintain it, this is essential. 

It takes time to build a positive payment history, so just be patient and don’t spend beyond your ability to repay. Also, you shouldn’t spend just for the sake of making on-time payments. Using your credit card for necessary purchases is more than enough to contribute to a positive payment history.

Credit Utilization: 30%

The second most important factor for determining credit scores is credit utilization. This is how much of your available credit (max amount) you are using. Typically this is expressed as a percentage. 

For example, if your available credit is $4,000 and your current balance (amount owed) is $1,000, you have a 25% credit utilization ratio. 

The standard rule of thumb for a healthy credit utilization ratio is below 30%. However, this doesn’t necessarily mean that keeping your utilization below 30% overall will guarantee good credit. Try to keep your utilization low across all individual accounts, as well as overall. So don’t be afraid to use your card because otherwise you’ll lose out on payment history, just be sure to spend within your means.

With this in mind, increasing your credit limit can result in lower utilization – as long as your spending doesn’t increase with it. 

Age of Credit: 15%

This is where patience really comes into play. You won’t achieve that perfect score you want without years of solid history under your belt, so as a teen you shouldn’t expect a perfect credit score. Don’t open an account just to let it sit though, because time since an account’s last transaction is also considered here. So avoid letting any accounts go stagnant and just try to be patient. It’ll be easy, time only goes faster from here (just ask anyone older than you).

Credit Mix: 10%

Also referred to as “credit diversity”, a full credit mix may be hard to achieve as a teenager. You typically don’t see many teens taking out mortgage loans and financing their own vehicles, but that’s okay. Having a solid payment history, growing credit age, and a record of low credit utilization will help compensate for this. You could consider a retail store card, getting a credit card through your bank or credit union, a secured credit card, or even your first auto loan, but don’t rush into it.

New Credit: 10%

This can be interpreted in a number of ways, but being only 10% of your score’s makeup, this isn’t anything to stress about. You can’t sit on the same accounts for too long, but you also want to avoid applying for too many new accounts within a short period of time. 

Applying for a new line of credit every few years should do the trick, although some recommend as often as every 8 or 9 months. In the youth of your credit life as a teen, there’s no need to put much emphasis here. 

Thinking about Credit Score Calculations

It’s important to understand how credit works and how your score is calculated, but the worst thing you can do is stress about these things and make poor financial decisions impulsively just for the sake of trying to build credit. 

Our best advice is to focus mainly on these things:

  • Spend within your means and pay off your balance, on time and every time. 
  • Keep your credit utilization low.
  • Be patient, good things will come.

What Your Credit Score is Used For

Like we mentioned before, credit scores are used by lenders, potential employers, and various other decision-makers in your life to gauge your trustworthiness and ability to pay back a debt to them. It all comes down to the risk that comes with those decisions. 

Knowledge of how credit scores are calculated and can influence these situations is crucial to building good credit.

Credit Score Ranges

You may find slightly different ranges for credit scores depending on where you look. Here are the ranges provided by FICO:

Credit RangeScore
Exceptional800+
Very Good740-799
Good670-739
Fair580-669
Poor<580

The general idea is that you’ll have a much easier time getting approved for an auto loan, home mortgage, or securing other financing with an “exceptional” score than with a “Good” or “Fair” one. You may also receive better rates and terms.

When you get into the lower scores in the “poor” credit category, you may still be able to get approved. However, you may require a special financing solution, often referred to as subprime lending.

What is the Highest Credit Score You Can Get?

The highest possible credit score that you can achieve using the standard FICO or VantageScore models is 850. 

However, you don’t need to get to 850 to be successful or consider yourself to have good credit. In fact, it’s not very likely that you’ll hit 850. Many consider any scores above 800 to be “perfect”.

The specific number isn’t so important to lenders, but rather the range that your score falls into. There are many factors in lending decisions even outside of credit considerations – so there’s no need to obsess over your specific number score.

Should You Check Your Own Credit Score? 

A common credit myth is that checking your score will cause it to drop. The key factor in whether or not credit checks will hurt your score is if they are a hard or soft credit inquiry.

Hard inquiries will affect your credit score. These most commonly occur when you apply for financing such as a loan or credit card. 

Soft inquiries will not affect your credit score. Checking your own credit score will result in a soft inquiry, so there’s no need to be concerned. In fact, there are many services that offer credit monitoring where you can log in to view your scores from various credit bureaus.

Monitoring your credit scores and reports is a very important part of maintaining good credit health.

What Affects Credit Scores

There are many financial decisions that you will make throughout your life that have the potential to directly impact your credit. As we mentioned already, applying for loans or credit accounts will result in hard inquiries that can impact your scores. 

Other things that can impact your credit score include:

  • Rent & Utilities – These are usually only reported when it impacts your score negatively, but you can talk to your landlord to get positive payments reported as well in some cases.
  • Filing Taxes – There are larger consequences to worry about regarding tax evasion than your credit score, but make sure you file your taxes properly each year.
  • Errors on your credit report – Monitoring your reports each year can help catch any discrepancies that could potentially be damaging to your credit. 
  • Unpaid Tickets and Bills – If any of these make it to collections, you could see your credit impacted.
  • Closing a Credit Account – Closing your credit accounts can impact several of the credit score calculation factors we discussed, including credit utilization ratio, credit age, and credit mix.

Credit is Unique

Keep in mind on your credit journey that each situation is unique. Having the knowledge of how credit scores work will equip you with the right information to make smart financial decisions and ultimately lead you to an excellent credit score. 

Each person may have slightly different determining factors, or at least the weight of them. And your credit scores may differ slightly by source or over time. This is all okay and expected – the general guidelines of how to build and maintain a great credit score is what’s important to follow.