How Credit Scores are Calculated

Credit Score Calculation

Credit scores are so important to people's financial lives that it's only natural to wonder: "Just how is my credit score calculated?" You’ll be relieved to know that a lot of people don’t fully understand what determines a credit score, and that’s okay! Our team at 1st Securities has the answers, and hopefully by the end of this article you’ll see that just because credit scores seem scary, doesn’t mean they have to be.

The Purpose of a Credit Score

Your credit score is one of the most important measures of your creditworthiness, and they exist as a way for lenders or financial institutions to assess a potential borrower’s risk level.

When you borrow money from one of these entities, they view you as a potential investment. Their profit comes from the interest that you as the borrower will pay them over the course of your mortgage loan. If you do not repay your monthly payments on time or at all, the lender is thus losing money. To avoid the risk of losing their profit as much as possible, the financial community developed a system to calculate whether you are going to be a sound investment—aka credit scores.

Having a high credit score signifies that, typically, you are a reliable borrower and financially stable enough to pay your bills on time. What this translates to in the eyes of a lender is that by accepting your application for a mortgage loan, they will more than likely turn a profit from their investment in you over the course of that loan.

Adversely, having a low credit score could be interpreted by the lender as a sign that you carry more risk as an investment. Being higher risk means a greater chance that the lender will not walk away with a net gain on their investment. Depending on how low your score is, some lenders may elect not to accept your loan application at all. They also may accept your loan application under more unfavorable conditions such as having to make a larger down payment or requiring mortgage insurance.

What Makes Up Your Credit Score?

By design, your credit score comes from the information found on your credit report. If an item doesn’t show up on a credit report, it can’t affect your score.

While banks may use their own methods of scoring, the FICO system is the most prominent. Thankfully, FICO is very clear about what their credit scores are composed of. This is namely:

  •       Payment History – 35%
  •       Amount of Debt Owed – 30%
  •       Length of Credit History – 15%
  •       Credit Variety – 10%
  •       New Credit – 10%

Payment History

Your payment history is just what it sounds like: a record of payments you have (or have not) made over the course of your credit. Payment history is typically the best indicator for lenders of the likelihood that you will pay back your loans as agreed upon.

There are a few things that go into the determination of your payment history. These are:

  •     Information on credit cards, installment loans, and mortgages
  •     Overdue/delinquent payments
  •     Number of past due items on a credit report
  •     Amount of time that has passed since delinquencies or collection
  •     The number of accounts being paid as agreed

Striving to pay all bills on time will help to increase your score, and to show potential mortgage lenders that you are a reliable borrower. Also, staying current on missed payments can positively affect your credit score, as the older a credit issue is the less it counts toward your score.

Payment history is the most important factor in a credit score, so it is essential that you monitor it closely and make paying your bills on time a top priority!


Amount of Debt Owed

Your amount of debt owed refers to the total amount of debt that you carry. Typically, your level of debt can be predictive of future credit performance because the amount owed impacts your ability to pay all monthly credit obligations on time. Carrying large amounts of debt that you are responsible for paying each month can indicate that you may be stretched thin and could have a difficult time making monthly payments.

Your amount of debt owed category of your score will look at the amount you owe on all accounts, which accounts have balances, your credit utilization ratio on revolving accounts, and how much of the installment loan amounts is still owed in comparison with the original loan.

Because your amount of debt owed category is the second most impactful one when determining your credit score, it is essential that you are more than comfortable making your monthly payments, and not struggling as the due date approaches.


Length of Your Credit History

You know what they say about fine wine: it only gets better with age. The same rule can apply to credit histories as well. Although people can still have a great score with relatively new credit if the rest of their categories are in tip-top shape, showing that you are reliable in paying off your debts over several years will always look better.

When it comes to the length of credit history, your score typically takes three things into consideration:

  1.     How long your credit accounts have been open including the age of your oldest account, the age of your newest account, and the overall average age of all your accounts 
  2.     How long specific credit accounts have been open, such as credit cards
  3.     How long it has been since the account was last used

It is best to begin dipping your toes into credit accounts early on, whether that is through student loans, credit cards, or a car loan so that when the time comes to apply for a mortgage, your credit history will be impeccable!


Credit Variety

Having a nice mix of credit account types and paying them off as agreed can help show lenders that you’re responsible and reliable. You might be wondering, why does that matter?

Well, the answer is simple and makes a lot of sense. Lenders like to see borrowers with a history of on-time payments across different types of accounts, to demonstrate consistent and responsible credit management. By having multiple lines of credit, you show that you can handle paying your credit cards, student loans, car payments, etc. all at once, and therefore can more than likely handle a mortgage. Diversifying your credit types is all about assessing your risk factor, and while it is by no means a make-or-break percentage of your overall credit score, you should consider branching out your lines of credit.


New Credit

Nowadays, people shop for new credit fairly frequently. Whether that is in the form of retail store credit cards, car loans, etc., acquiring new credit has become commonplace.

While new credit only accounts for 10% of your FICO score, opening a lot of new credit accounts in a relatively short period of time can signify to a lender that you carry greater risk. This is especially true for people who don’t have a long credit history.

So, how exactly does it work? When you apply for a new credit account, a hard inquiry is placed on your credit report. This means, for example, if you are applying for a new credit card, the lender will “inquire” into your credit report from one of the three major credit agencies. With each hard inquiry, your score will typically drop a few points, and we’ll explain why.

Hard inquiries cause your score to drop because the new line of credit affects your length of credit history. As we have already discussed, your credit history is made up of your oldest account and the average lifespan of all accounts. Therefore, opening a new line of credit will lower the average age of your total accounts and as a result lower your credit score.

However, credit inquiries will only remain on your credit report for two years and will no longer impact your score after one year.

So, what do the big credit agencies look at when they are assessing your new credit?

When looking at new credit, your score often considers:

  •       The total number of new accounts you have
  •       The total number of recent inquiries you have (within the past 12 months)
  •       How long it has been since you opened a new credit account

I know what you must be thinking. “You just said that having multiple different lines of credit was a good thing for your credit score!”

And this is still true! However, credit scores are all about balance and diversity over time, and overdoing it in one category, i.e., opening a bunch of new credit accounts at once, might be the reason why your score isn’t where you’d like it to be.


Factors That Don’t Affect Your Score

Checking Your Own Score: If you get your own score through your bank or a free credit score service such as Credit Karma, it won’t affect your score. This is because checking your own score is considered a soft inquiry, rather than a hard inquiry.

Rent and Utility Payments: In most cases, your rent and utility payments are not reported to the credit bureaus, so they do not count toward your score. The exception is if you use a rent-reporting service or if you are late on utility payments. The utility company may then charge it off or sell it to a collector, who can report it to the credit bureaus and hurt your score.

Income and Bank Balances: Credit reports do include some employer information, but it's used only to match account data to the right person. Getting a raise won't bump up your score, and it is possible to build credit on a small income.


Final Notes

As you can see, there are many factors that go into determining your credit score. It may seem overwhelming, but if you focus on making all payments on time, diversifying your credit slowly, and letting your credit score age a bit, you’ll be well on your way to having a fabulous credit report to score that new home of yours! Pun intended.

Are you looking to start your homebuying journey with a Lender for Life? Contact one of our 1st Securities Loan Originators today to get started!