tmount
Administrator
For a long time I had referenced credit scores in post, but never really wrote anything introductory like this, rather just talking about things like the best credit cards for reselling. In truth it’s a topic I understand but never considered myself an expert in. So I asked William Charles of Doctor of Credit, who is truly an expert in this stuff to write the following Introduction to How Credit Scores are Calculated. -Trevor
How Credit Scores are Calculated
Trevor asked if I might be interested in writing a guest post on how credit scores are calculated and here we are. In this post I’ll try to give you a primer on the different types of scores and how they are calculated. There are two major credit scoring algorithms:
- FICO Score
- VantageScore
General Credit Scoring Factors
Almost all credit scoring algorithms will look at the following, with slightly different weighting of importance:
- Payment History. The importance of looking at payment history data should be obvious. If you had two friends and one had always paid you back on time and the other was always late in paying you back who would you prefer to loan money to? The same is true for any financial institution and this is usually why payment history is the most important scoring factor.
- Credit Utilization. Your credit utilization is the amount you owe divided by the total amount of credit you have available to you. For example if you have one credit card (ridiculous I know) and it has a credit limit of $10,000 and you’ve used $1,000 of that limit your credit utilization will be 0.1 or 10%. The thought is that if somebody has used a high amount of the credit currently available to them then they are likely to be under financial strain or duress and more likely to default or become delinquent on their loans. It’s important to note that credit utilization traditionally has had no history (e.g credit scoring models will only care about what is currently being reported) but this is changing over time so expect utilization history to be more of a factor in the future.
- Length of Credit History. This helps qualify the rest of your data. If you’ve never made a late repayment and you’ve had a credit card for 20 years then you’re less likely to be a risk than somebody with no late repayments who has had a credit card for six months. This usually incorporates other factors as well such as age of newest account, oldest account and average age of accounts.
- Recent Searches For New Credit. Similar to credit utilization too many searches for new credit can be a signal that somebody is under financial duress and might be more likely to default/become delinquent on their loan obligations.
- Types Of Credit Used. There are two types of credit: installment & revolving. An installment loan is where you borrow a fixed amount and pay back the loan over time (think mortgage or auto loan) and revolving credit is where you have a fixed credit limit and can use/payback the loan as you see fit (think credit card).
This is the most used credit scoring brand (I think the last official figures were that it was used in 90% of all lending decisions, but that data is somewhat old). Their scoring breakdown or weighting looks like this for the classic score:
- Payment History: 35%
- Credit Utilization: 30%
- Length of Credit History: 15%
- Recent Searches For New Credit: 10%
- Types Of Credit Used: 10%
VantageScore
This is the second most used credit scoring brand and a brainchild of the three nationwide credit bureaus. VantageScore has never given specific weighting breakdown like FICO, instead they provide us with the following information:
Extremely Influential
- Payment history
- Age & Type of Credit
- % of Credit Used (also known as credit utilization ratio)
- Total Balances/Debt
- Recent Credit Behavior and Inquiries
- Available Credit
- Recent credit: 30%
- Payment history: 28%
- Credit utilization: 23%
- Credit balances: 9%
- Depth of credit: 9%
- Available credit: 1%
What You Should Do To Improve & Maintain Your Score
Once you understand how credit scores are calculated, what you should do becomes a lot clearer. Here are my tips:
- Always pay your bills and repayments on time. You’re hopefully doing this anyway to avoid late payment and interest charges but remember that your payment history is the key scoring criteria for both of the major scoring models. If you’re forgetful then set up automatic repayments.
- Keep your utilization low. It’s generally considered best to keep your credit utilization at 1-10%. Keep in mind that the credit utilization is based on what is reported to the three nationwide credit bureaus and they all have different reporting dates. This means even if you pay your balances in full every month you might be reporting a large balance. You can see what date card issuers report to the credit bureaus on Doctor of Credit.
- Product change instead of canceling. Credit length is important so instead of cancelling a credit card with an annual fee why not see if there are any useful no annual fee options you can product change that card to instead? That will help keep your average age of accounts higher than cancelling would. (Note: Currently FICO allows closed accounts to continue to age on your credit report until they fall off after 7 years so this isn’t hugely important. I believe they will be making changes to this in the next scoring iteration as it doesn’t currently make sense from a risk perspective).
Questions On How Credit Scores Are Calculated?
Feel free to ask below and I’ll do my best to answer them. Obviously this is just an introduction how credit scores are calculated, and you should do your own research but hopefully this is helpful to some readers. Thanks again to Trevor for inviting me onto the blog. Credit scoring is actually why I originally started my own blog so it’s nice to share this sort of information!
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