A guide on how to calculate credit scores

Are you curious about how lenders evaluate your creditworthiness? Understanding how to calculate credit your score is crucial for anyone looking to navigate the world of borrowing and lending. In this comprehensive guide, we’ll delve into the intricacies of credit scoring, demystifying the process and equipping you with the knowledge to take control of your financial health. From the factors that influence your credit score to the various scoring models used by creditors, we’ll cover it all. Additionally, we’ll explore practical tips for improving your credit score and debunk common myths surrounding credit scoring. By the end of this article, you’ll be empowered to make informed decisions about your finances and take steps toward achieving a healthier credit profile.

What is a credit score?

A credit score is a numerical representation of an individual’s creditworthiness, providing lenders with insight into their likelihood of repaying debts. It’s calculated based on various factors such as payment history, credit utilization, length of credit history, types of credit accounts, and new credit inquiries. Typically ranging from 300 to 850 in the United States, higher scores indicate lower credit risk, making it easier to qualify for loans and obtain favorable interest rates. A good credit score demonstrates responsible financial behavior, while a poor score may indicate past credit problems or higher risk to lenders. Credit scores play a pivotal role in financial decisions, influencing access to credit, loan terms, insurance premiums, and even employment opportunities.

Factors that affect your credit score

On the road to building your credit score, you need to know the factors that affect it. Let’s have a look at them:

Payment history

This comprises 35% of your credit score, reflects your consistency in making on-time payments. Lenders view missed or late payments as red flags, potentially lowering your score. Conversely, a history of timely payments enhances your creditworthiness.

Credit utilization

This accounts for 30% of your score, measures the proportion of your available credit that you’re using. High credit card balances relative to your credit limits can signal financial strain and lower your score. Experts recommend keeping your credit utilization below 30% to maintain a healthy score.

Length of credit history

This contributes 15% to your score. Lenders assess how long you’ve had credit accounts, favoring established credit histories. A longer credit history offers more data for lenders to evaluate your creditworthiness, potentially boosting your score. It’s beneficial to maintain old accounts, as they demonstrate responsible credit management over time. Therefore, a lengthy credit history with a positive payment record can positively influence your credit score.

Types of Credit

The types of credit you have are a significant factor in your credit score. This aspect considers the mix of credit accounts you hold, including revolving accounts like credit cards and installment loans such as mortgages or auto loans. Having a diverse mix of credit types can positively impact your score as it demonstrates your ability to manage different types of credit responsibly.

New Credit Inquiries

New credit inquiries reflect recent credit applications or inquiries made by lenders when you apply for credit. Each inquiry can have a small negative impact on your score. Multiple inquiries within a short period may suggest higher risk to lenders, potentially lowering your score. However, multiple inquiries for the same type of credit (e.g., mortgage or auto loan) within a short period typically count as a single inquiry.

Credit Account Age

The age of your credit accounts also plays a crucial role in determining your credit score. It reflects how long your credit accounts have been open, with older accounts contributing positively to your score by indicating a longer credit history. Closing old accounts can shorten your credit history and potentially lower your score. Therefore, it’s advisable to keep older accounts open and active to maintain a longer credit history, positively impacting your credit score.

Credit Mix

Your credit mix refers to the variety of credit accounts you have, such as credit cards, installment loans, mortgages, and retail accounts. Lenders like to see a diverse mix of credit types, as it indicates that you can manage different types of credit responsibly. Having a mix of revolving credit (e.g., credit cards) and installment loans (e.g., mortgages or auto loans) can positively impact your credit score.

Public Records

Public records include information such as bankruptcies, foreclosures, liens, and judgments. These records can significantly impact your credit score, usually resulting in a significant decrease. Bankruptcies and foreclosures have the most severe negative impact on credit scores, while judgments and liens can also cause significant damage.

Debt-to-Income Ratio

Your debt-to-income (DTI) ratio is a measure of your monthly debt payments relative to your monthly income. While not directly factored into your credit score, lenders often consider DTI when evaluating your creditworthiness. A high DTI ratio suggests that you may have difficulty managing additional debt, which can impact your ability to qualify for new credit or favorable interest rates.

Credit Inquiries

Credit inquiries occur when lenders or creditors check your credit report in response to a credit application you’ve made. There are two types of credit inquiries: hard inquiries and soft inquiries. Hard inquiries, generated by credit applications, can temporarily lower your credit score. In contrast, soft inquiries, such as those from pre-approved credit offers or when you check your own credit, do not affect your score. Multiple hard inquiries within a short period can signal higher risk to lenders, potentially lowering your credit score. Therefore, it’s essential to be mindful of how often you apply for credit to avoid excessive inquiries.

How to calculate your credit score

To calculate your credit score effectively, follow these steps:

  1. Obtain your credit report: Request your credit report from one of the major credit bureaus—Equifax, Experian, or TransUnion. You’re entitled to one free report from each bureau annually through AnnualCreditReport.com.
  2. Review the information for accuracy: Scrutinize your credit report for any errors, such as incorrect personal information, accounts you didn’t open, or inaccurately reported payment history. Dispute any discrepancies you find to ensure your credit report reflects accurate information.
  3. Understand the weight of each factor: Familiarize yourself with the factors that influence your credit score, including payment history, credit utilization, length of credit history, credit mix, and new credit inquiries. Each factor carries a different weight in determining your overall score.
  4. Assign values to each factor based on their importance: Assess the significance of each factor in relation to your overall credit health. For example, prioritize maintaining a positive payment history and keeping credit card balances low, as these factors heavily influence your credit score. Adjust your financial habits accordingly to improve your creditworthiness over time.
  5. Calculate the weighted average: Assign weights to each factor based on its importance in determining your credit score. For example, payment history typically carries more weight than credit inquiries. Calculate the weighted average by multiplying each factor’s value by its assigned weight and summing the results.
  6. Utilize online tools or consult with a financial advisor: Take advantage of online credit score calculators or seek guidance from a financial advisor to navigate the complexities of credit scoring. These resources can provide insights into how specific financial behaviors impact your credit score and offer personalized advice for improvement.
  7. Monitor your credit regularly: Stay vigilant by monitoring your credit report and score regularly. Regular monitoring allows you to identify any discrepancies or negative changes early on, giving you the opportunity to address them promptly and maintain a healthy credit profile.

How to raise your credit score

Improving your credit score requires consistent effort and financial responsibility. Here’s how to raise your credit score:

  1. Pay bills on time: Your payment history is a significant factor in determining your credit score. Make timely payments on all your bills, including credit cards, loans, and utilities, to demonstrate reliability to creditors.
  2. Reduce credit card balances: Aim to keep your credit card balances low relative to your credit limits. High credit utilization can negatively impact your credit score, so focus on paying down balances to improve your credit utilization ratio.
  3. Limit new credit applications: Each new credit application generates a hard inquiry on your credit report, which can temporarily lower your score. Be selective about applying for new credit and avoid opening multiple accounts within a short period.
  4. Monitor your credit report: Regularly review your credit report to identify any errors or discrepancies. Dispute inaccuracies promptly to ensure they don’t drag down your credit score.
  5. Diversify your credit mix: Having a mix of credit types, such as credit cards, installment loans, and mortgages, can positively impact your credit score. If feasible, consider diversifying your credit portfolio to demonstrate responsible credit management.
  6. Keep old accounts open: Length of credit history is a key factor in your credit score. Avoid closing old accounts, as they contribute positively to your credit age and overall score.

By following these steps consistently and responsibly managing your finances, you can gradually raise your credit score over time.

Bottom Line

Understanding how credit scores are calculated is crucial for managing your financial health. By grasping the factors that influence your score and learning how to interpret your credit report, you can take proactive steps to improve and maintain a healthy credit profile. Remember, achieving a good credit score requires diligence, discipline, and responsible financial habits. Whether you’re looking to secure a loan, rent an apartment, or qualify for better interest rates, the knowledge gained from this guide empowers you to navigate the world of credit with confidence. Stay informed, monitor your credit regularly, and take action to optimize your creditworthiness for a brighter financial future.