How Is Your Credit Score Calculated?

March 16, 2009 — -- A young reader asked me last week how your credit score is calculated, how it's related to your credit report and how you find out your score. It was a great reminder that a lot of the consumer vocabulary I use is just mumbo-jumbo to folks who don't work in this world every day like I do. So here goes: Credit Scoring 101.

Your credit score is simply a three-digit number that predicts whether you'll pay back your loans and pay them on time. Scoring formulas are closely guarded but a typical scale ranges from 300 to 850. Before the economic crisis , a score of 680 or more qualified you for the very best mortgage interest rates. Now, credit has tightened up, and lenders are only offering the best rates to people with scores of 720 or even 740 and above. Your credit score is not static. It changes with every single payment you make or fail to make.

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Keep in mind that every bank does it differently, so your score could vary depending where you apply for credit. That's why if you are turned down for credit at one institution, you should apply to others. They may have different data on you or different standards.

So how is your credit score calculated? Statisticians studied peoples' payment patterns for years. They looked at things like late payments, kinds of credit, home ownership, how long you'd had credit cards, and the ratio of debt to available credit. They learned which factors are good predictors that you're likely to pay your bills. Then they assigned numerical values to those predictors and created statistical models.

Where does the raw information come from to create a score? From the credit reports kept on you by the big three credit bureaus: Equifax, Experian and Transunion. If that raw data is inaccurate, it will hurt your score. That's why it's so important to order your credit reports regularly at www.annualcreditreport.com, the only truly free source of credit reports. Check the reports and if you find mistakes, fill out the simple form to dispute them. But I digress.

Boost Your Credit Score: No Accounting for Empathy

Banks are not allowed to make race, gender, marital status, national origin or religion a factor in their credit scoring models. They are allowed to use age as a predictor, if they can prove their model is well designed and doesn't discriminate against the elderly.

Credit scores are less biased than bankers. After all, scoring applies the same mathematical, methodical standards to everybody. The one thing that's missing is human empathy. If your late payments are the result of an illness in the family, for example, the scoring model won't account for that. In those cases, many banks allow you to plead your case to a real live human.

Credit scoring is fast and impartial but it's not perfect. Here are a couple of examples. A person can be filthy rich and have a terrible credit score. Credit scoring models give preference to people who have credit, use it and pay it off responsibly. If somebody is so wealthy that they pay cash for most things, they won't have much of a credit history and that will hurt their credit score. That person could be turned down for a Sears card. For that matter, if you're not rich, but you just don't believe in using credit cards, you could score low and have trouble qualifying for a bigger loan when you want it.

Credit card companies were the first to use credit scoring. Auto loans came next. Banks started basing their mortgages and small business loans on credit scores in the 1990s. Today, even insurance companies use credit scores to decide whether they want to issue you a policy. They've discovered a correlation between people who pay their bills late and people who make excessive insurance claims. Credit scores are bound to come into play in other industries too.

If you're going to win at this game, it's important to "know the score." For many years, banks and credit scoring companies resisted telling consumers their scores. Not anymore. Now they're eager to sell them to you. Equifax, Experian and Transunion all sell credit scores for about $15. But I would order from www.myfico.com first. That's the site run by Fair Isaac, the company that invented credit scoring. The "FICO" score is still the most commonly used.

Pay on Time, Wipe Out Debt, Raise Credit Score

If you are pursuing a major loan, you may want to order from the credit bureaus as well, because your score with each is slightly different based on the different data they have on you. You could try to find out which credit bureau your lender uses and focus on that one.

If you don't like what you see, can you improve your score? Yes. Fortunately, scoring models put more emphasis on the present than the past. So with every bill you pay on time and every debt you wipe out, your score will rise.