How a Credit Score Is Calculated

Given today’s market, having a good credit score is much more important than it was even one year ago. In order to qualify for a home loan, lenders are requiring higher scores—many lenders are charging higher interest rates for people who have scores lower than 680, or even 700. Borrowers with a credit score of less than 660 will find it hard to qualify for any loan, unless they go with an FHA product.

What does this mean to potential homebuyers? Well, to start with, if a buyer has a lower credit score, the interest rate on their home loan could be as much as .5 to .75 percentage points more than a buyer with a high credit score. That means that they will have less purchasing power after taking the maximum monthly payment the buyer can afford into consideration.

So how are credit scores computed?

A credit score is a number generated by a mathematical algorithm—a formula—based on information on the credit report, compared to information on tens of millions of other people. The resulting number is a highly accurate prediction of how likely the person will pay bills on time.

Scoring Categories

Lenders can use one of many different credit-scoring models to determine if a person is creditworthy. Different models can produce different scores. However, lenders use some scoring models more than others. The FICO score is one such scoring method.

Its scale runs from 300 to 850. The vast majority of people will have scores between 600 and 800. A score of 720 or higher will get you the most favorable interest rates on a mortgage, according to data from Fair Isaac Corp., a California-based company that developed the first credit score as well as the FICO score.

Currently, each of the three major credit bureaus uses their own version of the FICO scoring method—Equifax has the BEACON score, Experian has the Experian/Fair Isaac Risk Model and TransUnion has the EMPIRICA score. The three versions can come up with varying scores because they use different algorithms. Variance can also occur because of differences in data contained in different credit reports, which is why it is so important for a homebuyer to check reports from all three bureaus for errors.

Key Factors of Your Score

Just what goes into a score? “Everything in your credit report, with different kinds of information carrying differing weights,” says Fair Isaac Corp. Public Affairs Manager Craig Watts. The FICO-scoring model looks at more than 20 factors in five categories.

1. How You Pay Your Bills (35% of the score): The most important factor is how you’ve paid your bills in the past, placing the most emphasis on recent activity.

2. Amount Of Money You Owe and the Amount of Available Credit (35% of the score): The second most important area is your outstanding debt—how much money you owe on your credit accounts. Also considered is the total amount of credit you have available. If you have 10 credit cards that each have $10,000 credit limits, that’s $100,000 of available credit. Statistically, people who have a lot of credit available tend to use it, which makes them a less attractive credit risk.

3. Length of Credit History (15% of the score): The longer you’ve had credit—particularly if it’s with the same credit issuers—the more points you get.

4. Mix of Credit (10% of the score): The best scores will have a mix of both revolving credit, such as credit cards, and installment credit, such as mortgages and car loans. “Statistically, consumers with a richer variety of experiences are better credit risks,” Watts says. “They know how to handle money.”

5. New Credit Applications (10% of the score): he final category is your interest in new credit—how many credit applications you’re filling out. The model compensates for people who are rate shopping for the best mortgage or car loan rates.