Before extending a loan or a line of credit, lenders evaluate the likelihood that borrowers will be able to pay them back. One way to do this is to look at a borrower’s credit score. Credit scoring uses a formula to reduce a person’s complicated credit history into one simple number. Before trying to borrow money, it helps to understand how your credit score is calculated and what it says about your ability to get a loan.
Credit score basics
Different agencies each have their own way of calculating your credit score. The number will typically be on a scale from 300 to 850, with a higher number meaning that you are more likely to repay a loan and make payments on time. Your credit score changes all the time. Every payment you make (or miss) and any new credit you receive affects it.
How credit scores affect loans
Because your credit score predicts your risk, it influences both your ability to get a loan and the interest rate of your loan if you are approved. People with a higher credit score will have less trouble getting a loan and are likely to receive loans with lower interest rates.
Why use a number?
Lenders are not allowed to discriminate based on factors like race, sex, gender, religion, marital status or national origin. A credit score uses a mathematical formula to calculate your loan risk based on your past credit history alone. This creates a more accurate way of predicting your likelihood of repaying a loan, while also trying to remove potential human bias.
There are different ways for calculating your credit score, but the most common, known as FICO scores, were created by Fair Isaac and Company. Different credit scoring agencies may have their own version of FICO scores. Equifax has the Beacon Score, Experian uses the Experion/Fair Isaac Risk Model and TransUnion calls its score Empirica. FICO scores are created from five different types of information in your credit report, which each category making up a certain percentage of the decision:
- Payment history (35%) — The history of previous credit or loans shows your record for making payments. Missed or late payments, past due items and accounts in delinquency will lower your credit score. It also shows the number of accounts you have paid as agreed.
- Amounts owed (30%) — This shows the amount you currently owe on loans or lines of credit. It looks at the number of accounts you have open and the balances on each account.
- Length of credit (15%) — This factor looks at how long you have had different credit accounts and how long it has been since there has been activity on each account.
- New credit (10%) — This refers to the number of recently opened accounts, as well as the number of recent credit inquiries. It also looks at how long it has been since new accounts were opened and if you have re-established positive credit after a past payment problem.
- Types of credit (10%) — The different types of credit you have (e.g., credit cards, mortgages, installment loans) is also considered.
Average FICO scores
FICO scores are calculated on a scale with results typically ranging from 300 to 850. Lenders have their own way of evaluating credit scores. Some might say a good score is anything over 600, others say a score isn’t considered good until it reaches 720. The credit score requirements for loans have also gone up in the last few years. A high credit score would be 720 or higher, a medium score ranges from 625 to 719 and a low score is anything under 625.
Differing credit scores
Various credit agencies are likely to give you a different credit score. This is partly because each has its own way of calculating credit scores. It is also because each credit agency only uses the information it has available. If one agency finds a delinquent account that another agency misses, it is likely to report a lower score.
Improving credit scores
Credit scores are not static. Scores change every time you make a payment, miss a payment or open new lines of credit. They even change simply as time passes. If you have a lower credit score, you can improve it by taking care of delinquent accounts and making all of your future payments on time. If your score is low because you haven’t used as much credit, opening a credit card and making timely payments will build a strong credit history.