How is a credit score calculated?

Credit scores are a way to grade you on your creditworthiness. Each of the three credit bureaus rates your social security number based on your credit history, and you are assigned a number from 300 to 850 called a FICO score.

The higher your score, the more likely companies are to loan you money. If your score is above 740, you have excellent credit, and if it is below 650 you will pay higher interest rates on the credit you receive and have a harder time getting credit.

We know you’ve seen the advertisements about checking your credit score and how important it is to keep tabs on it, but why is it such a big deal?

Your credit score is a big deal

Creditors use your credit score to judge whether or not to loan you money. If you have a low score, companies may deny you credit. Having a higher score could mean lower interest rates, lower monthly payments and more opportunities to get credit.

These days credit scores are not just used by banks and other lenders. Insurance firms, landlords and even employers are using them to judge how responsible you are.

Knowing what makes up your credit score may help you get that job or apartment, and it will save you money in the long run.

What affects credit score?

The algorithm that the credit bureaus use to come up with your credit score is a closely guarded secret and is different for each bureau. However, we know the primary factors they consider and the approximate weight those factors are given when determining your score.

Payment history (35%) – Each bureau is going to look at your payment history with companies that have loaned you money, whether it be credit cards, student loans, car loans or a mortgage. If there are any late or missing payments, they will lower your score.

Amounts owed (30%) – The ratio between how much you owe and your available credit is called your utilization ratio. If you have maxed out all your credit cards, the bureaus believe you will be more likely to miss payments, so your score will be lower.

Length of credit history (15%) – Generally, the older your credit accounts are, the better it is for your credit score. Try to keep old accounts going, instead of applying for new credit. The bureaus will also look at how long it’s been since each account was used.

New credit accounts (10%) – If you recently opened a bunch of new credit accounts, this will affect your score negatively. The new accounts shorten the average length of your credit history.

Types of credit (10%) – The bureaus are looking to see if you can handle multiple types of credit, such as revolving debt accounts (credit cards) and installment loans (mortgages, auto loans, student loans, etc.).

How to keep a healthy credit score

Check your credit report – Checking your credit report does not negatively affect your score, and you can do it free once a year. Go to annualcreditreport.com to get a report from each of the three bureaus. Check for any incorrect information and contact the bureau so they can investigate.

Pay your bills on time – This may seem like a no-brainer, but it is the best way to develop and keep a good credit score.  Use autopay to help you ensure your payments are always right on time.

Use no more than 30% of the credit available to you – If you keep your balances low, your credit score will be higher.

Keep accounts open longer or become an authorized user – Keeping your accounts open for a longer time will help your credit rating. You can also become an authorized user on someone else’s credit card, and this will help you develop a good credit history and improve your credit score.

Have a mix of credit accounts – It is better to have a mix of credit types, such as revolving debt accounts (credit cards) and installment loans (those with fixed monthly payments). This lets the credit bureaus know you can handle multiple types of debt and still pay them on time.

Don’t recklessly apply for credit – Each time you apply for credit, of any kind, it creates a hard inquiry record on your report. If you get a bunch of these in a short time, it is bad for your rating.

Pay off your debt – Generally, the quicker you pay off your debt, the better your credit score will be. Make sure your payments are on time and don’t miss any.

In a nutshell

Your credit score affects not only how much money you can borrow, it can affect the interest rate you pay, your monthly payment amount, and even affect your ability to get a job or rent an apartment.

Paying your bills on time, not using too much credit, keeping accounts open, having a variety of credit types, and not applying for too many credit cards can help you have a good credit score that will allow you to borrow money at a reasonable interest rate.

Dawn Killough

Personal finance writer

Dawn Killough is a personal finance freelance writer from Salem, Oregon, where she lives with her husband and four cats. When she isn’t writing, she enjoys reading romantic mysteries and dreaming of the beach. Find more of her work on www.dkilloughwriter.com.