How Credit Scores are Calculated

Before credit reports and credit scores existed, applying for a loan was a riskier process, for both the borrower and the lender. Bankers and other lenders had to guess at an applicant’s creditworthiness. Borrowers had to rely on the judgment of the lender, and sometimes people who deserved a loan didn’t get one, while others who weren’t good applicants still secured loans.

Credit report and credit scores are intended to take the guesswork out of the credit approval process. Because they record the history of your actual past credit and payment behaviors, credit reports and credit scores are considered valuable indicators of a person’s likelihood to repay a loan.

Credit reports are histories of all your financial obligations and how you’ve managed them. Credit reporting agencies use the information contained in your credit report to calculate your credit score when a lender or creditor requests it. Generally, the higher your score, the more creditworthy lenders view you, and the more likely you are to get the credit you desire at favorable rates and terms.

Score Variables: What Does and Does Not Impact Your Scores

When you apply for credit, the lender will ask the credit reporting agency for your credit score. The bureau summarizes the information contained in your credit report into a set of score variables. While each credit reporting company uses its own formula to determine variables, most formula and resulting variables are very similar.

For example, one important variable compares how much credit you have available to how much you’re actively using. In other words, if you have credit cards with limits totaling $5,000, the credit score formula compares that to the balance that you actually owe on those cards. Other common score variables include:

  • Number of late or missed payments
  • Number of hard inquiries – those made by lenders to whom you’ve applied for credit
  • Average age of accounts, which shows how long you’ve been managing credit
  • Number of open installment loans
  • Average credit card limit

In addition to understanding what factors do impact your credit score, it’s also important to know what doesn’t. Things that are never factors in your credit scores (and in some cases don’t even appear on your credit report) include:

  • The number and balances of your banking accounts or other accounts such as investment accounts
  • Your gender
  • Your race or ethnicity
  • Education level
  • Income

Making Credit Scores

Once all your score variables have been figured out, they go into a massive equation that produces a credit score. Every company calculates its credit scores a little differently, but some basic concepts are fairly standard:

  • Credit Scores Generally Start in the Middle, and then Move Up and Down. Every credit reporting agency has a range for its credit scores. Instead of your score starting at the lower or higher end and then gaining or losing points, it really starts in the middle. You earn points for good credit behaviors like making on-time payments, and lose points for poor ones such as maxing out your credit cards. Based on this method of calculation, a higher score means you’ve earned more points for good credit habits.
  • Credit Scores are Based on Math, Not People. Although lenders consider many factors when evaluating a credit application, and the ultimate decision to lend or not lend lies with people, credit scores are not driven by lender perceptions. They’re based on the record of your credit behaviors processed through a complex mathematical formula.
  • Some Score Variables are More Important than Others. Differences in credit scoring formula are usually minor. The big, important stuff – like payment history and credit usage – stays the same. In fact, those two factors usually have the greatest influence on your credit scores, no matter what credit reporting agency is doing the calculation.

The most important thing to remember about credit scores is that you can influence yours through your credit-related actions. Every credit or financial decision you make can affect your scores. Understanding how certain behaviors may impact your credit scores can help you improve how lenders perceive your creditworthiness and responsibility.