Whether you are applying for a personal loan, purchasing a vehicle, or trying to buy your first home, credit scores play a critical role in ensuring you get the best deal possible. With the cost of living skyrocketing and home ownership more cost-prohibitive than ever, understanding how to maximize this score is more important than ever. Below, we look at how these scores are calculated, who is calculating them, and more in a brief FAQ.
What is a Credit Score?
A credit score represents a person’s perceived creditworthiness—that is, how likely a person is to repay a loan in a reliable and timely fashion. Depending on where you reside, these scores are typically presented as a tiered number system with rankings ranging from ‘poor’ to ‘excellent’.
What is its Purpose?
The primary purpose of a credit score is to provide financial institutions with a quick way to assess the risk of lending to a borrower objectively. As mentioned, these scores are used to predict how likely someone is to repay borrowed money and make payments on time. The score guides lenders in deciding whether to extend credit, the terms of the credit, and the interest rate. Naturally, when taking on more risk, lending terms offered are less favorable to the applicant.
What is a Good Score?
So, what constitutes a good score? In the United States, credit scores can vary depending on the model being used (e.g., FICO or VantageScore) and the lender’s criteria. Typically, though, scoring tiers are broken down as follows:
- Excellent: 800 and above
- Very Good: 740 to 799
- Good: 670 to 739
- Fair: 580 to 669
- Poor: Below 580
When applying for a loan of any kind, the higher the tier you reside in, the better interest rates you can expect.
How are they Generated?
A higher score is better – that much is easy to understand. Where credit scores become a little more murky, requiring a bit more insight, is how they are calculated. Does one’s history of repaying loans come into play? Or does the number of open loans you already play have the largest role?
Basically, modern credit scores are generated using algorithms that analyze a person’s credit report data. This data comprises various factors, each holding a different weight/importance in generating a score. These include,
- Payment History (35%): This is the most significant component of your credit score, as your payment history is the best indicator of whether or not you are reliable at meeting your financial obligations. When looking at payment history, credit bureaus assess your payment track record for credit cards, retail accounts, installment loans, finance company accounts, and mortgages. Obviously, late payments, bankruptcies, and foreclosures will negatively affect this portion of your score for a time.
- Amounts Owed or Credit Utilization (30%): This is the second most crucial factor and is often referred to as credit utilization ratio—how much of your available credit you use. A lower utilization ratio typically lets lenders know you haven’t overextended yourself and can manage credit well. As a rule of thumb, keeping your total owing balances below 30% of the credit available to you across accounts is often recommended.
- Length of Credit History (15%): This factor considers the time each credit account has been open and the time since the account’s most recent action. A longer credit history can benefit your credit score if managed responsibly.
- New Credit (10%): This includes the frequency of credit inquiries and the number of new accounts opened. Lenders might consider opening several new credit accounts in a short period risky because it might indicate financial trouble. Be mindful when shopping around for rates on lending products, as ‘hard checks’ can negatively impact credit scores. Verify that only ‘soft checks’ are utilized before authorizing such actions.
- Types of Credit in Use (10%): This refers to the mix of accounts you have, such as credit cards, installment loans, finance company accounts, mortgage loans, etc. By having a diverse mix of credit types, you are showing that you can responsibly manage your finances across various products as a whole. Doing so well can positively affect your score, although it’s less significant than other factors.
The take-home point here to how credit scores are generated is that one should strive for access to a diverse set of financial products while ensuring timely payments over a long period of time and not tapping into all of the funds made available to you.
Who is Responsible for Generating a Credit Score?
Now that we know what credit scores are, what constitutes a good score, and how they are calculated, who is responsible for generating them? This role comes down to what are known as ‘credit bureaus.’ In the United States, the major credit bureaus are Experian, TransUnion, and Equifax. While each bureau uses its own data and scoring models, most utilize common scoring formulas such as FICO.
What is FICO?
FICO, originally known as Fair, Isaac, and Company, is the analytics company responsible for the FICO score. Released in 1989, it is commonly viewed as the first credit scoring system, with most lenders using it today.
It should be noted that while the credit score system is very similar across North America, the numerical scale and accompanying tiers differ in Canada compared to the United States. North of the border, the major credit bureaus are Equifax Canada and TransUnion Canada.
The main difference is that Canadian credit scores range from 300 to 900, as opposed to the upper limit of 850 typically used within the U.S. system. Approaches to determining a score are much the same, however each credit bureau may place slightly different weighting on considered factors. While other minor differences exist surrounding privacy controls and who can access credit scores, the concept is much the same.
Credit Repair
Note that if you suffer from poor credit, do not be dismayed. These scores are in constant flux, and with thoughtful oversight of one’s finances, they can typically be improved in a short amount of time. For a closer look at how this can be done, consider some of our recommended credit restoration strategies.