Credit Scores: A Comprehensive Guide

How Credit Scores Are Actually Calculated

There is a frustrating opacity around the calculation of credit scores. Most explanations will note that credit scores are based on proprietary credit scoring models and complex calculations. Some explanations go a little bit further and detail some of the inputs into these credit scoring models and their relative importance to determining credit scores. These inputs are known as “attributes” and include information that generally falls into one of six categories:

• Number of credit accounts (e.g. number of credit cards)
• Type of credit accounts (e.g. credit cards, installment loans, mortgage loans)
• Bill paying history (e.g. late payments, on-time payments)
• Length of time a consumer has had a credit account
• Amount of available credit
• Recent inquiries (hard inquiries only)

Credit Scores are calculated by taking the various attributes that underlie each of these six categories and feeding them into a credit scoring model. How this model works is where the opaqueness starts, and to complicate matters further, there are multiple credit models with the two most popular being FICO and Vantage Score. However, lenders can also (and frequently will) request specific credit models when purchasing credit scores from the credit bureaus. So it is indeed complicated. However, we do know a few things. For starters, not all attributes are equal and one of the helpful pieces of information the credit bureaus have revealed over the years is the relative importance of each of the attributes.

The above chart shows the relative importance of the attributes based on information from FICO and Experian. Intuitively this makes sense. Your payment history and the total amount of credit outstanding represent almost two thirds of the weighting when it comes to the computation of your credit score. It makes sense that the most important consideration when calculating your credit score is how often you’ve missed payments since that has to be a precursor to defaulting on a loan. The amount owed in this instance refers to the total debt outstanding, the type of debt and your credit utilization, which is the percentage of the credit that has been extended to you that has also been drawn. Credit scoring models use the amount owed (and specifically the credit utilization piece of it) to predict future credit performance. Even if you have a high amount owed, if you are showing continued progress in reducing this balance through consistent monthly payments, this will be a positive for your credit scores. Similarly, if you are only utilizing a small fraction of the revolving credit (credit card debt) that’s available to you, that is also an indication that you’re in a healthy financial situation and using credit responsibly.

Credit Scores Are Relative Measures

We also know that credit scores are a relative measure. All credit scoring models rank consumers’ relative likelihood of defaulting on credit. Again, intuitively this makes sense as a higher credit score should represent a person that has a lower likelihood of defaulting on credit compared to people with lower credit scores. Viewed another way, if someone has missed 10 payments in their life, it makes sense to assess this relative to the rest of the population – if on average people tend to miss 50 payments, then shouldn’t this consumer deserve a higher score for this attribute compared to the general population?

In summary, your credit score is calculated by accumulating the attributes from your credit report and inputting them into a credit model that performs a computation which we know includes a mathematical weighting according to the relative importance of the attribute, and also a weighting compared to all U.S. consumers.

What You’ll Find in Your Credit Report

While there will be variations in how the three credit bureaus compile and present your credit information, they are substantively the same. This is something you can check for yourself by accessing a free copy of your report at Annual Credit Report. In general your credit report will including information that falls into four categories:

• Personally Identifiable Information (PII) – this is standard information about you and includes facts such as your name, date of birth and Social Security Number. This information is used to determine the person that possesses the credit information.
• Details on Your Credit Accounts – this category lists the different lenders that you have accounts with. It will show the lender’s name, type of account, date of opening the account, the outstanding balance of the credit (loan amount or credit limit) and will also include payment information. If you’ve missed payments or had delinquencies on specific accounts, this is where it would be listed.
• Details on Your Credit Inquiries – this category lists each occurrence that someone has accessed your credit report over the preceding two years. When you request your credit report it will show both hard and soft inquiries (discussed below). This is an important category to monitor as if you do not recognize certain items it could be indicative of someone accessing your personal information.
• Public Record and Collections – this category consists of public record information from  various state and county courts. Debt that is past due and that gets sent to collections will also appear in this section. Bankruptcy filings, which go through the court system, will also appear in this section of your credit report.

These are the four categories of information that you’ll find on your credit report, no matter which credit bureau is providing the report. It’s a good practice to review these at least once a year and to make sure there are no errors or other issues which could be negatively impacting your scores.

How Lenders Use Credit Scores

The objective of a credit score is to provide lenders with a standardized measure of a consumer’s credit risk, that is, the likelihood that a consumer will become 90 days delinquent on a new loan within two years¹. Lenders purchase two things from the credit bureaus: the credit report which has detailed information on the consumer, and the consumer’s credit score. As discussed in the prior section, lenders often will request that the credit bureaus utilize specific models in computing the credit scores they provide to the lenders. This is because different lenders have different requirements. For example, if you are lender that provides installment loans, which are very different from credit cards or mortgages, you might want a credit model that provides a particular emphasis on how consumers have performed with installment loans. Aside from this, lenders might have preferences for one credit model over another due to their specific underwriting standards.

The chart above shows the mix of credit models that were used in mortgage originations in California in 2020 as disclosed by the Home Mortgage Disclosure Act². This should give you an idea of the variation in credit models used for just one type of credit: mortgages. In fact, the three credit bureaus offer their customers several options when it comes to FICO Scores to allow their customers to pick and choose the type of risk score they’re interested in. A report by the NY Times discussed the fact that there were at the time, 49 different FICO scores being offered to lenders! These are some examples of different scoring models from Equifax:

• BEACON 5 Auto – this FICO score is an automotive industry-specific risk score
• BEACON 9 Mortgage – this FICO score is a mortgage industry-specific risk score
• Inscore 3 Property (Renters) – this score is tailored for property insurers that are renters

However, while the availability of different scoring means that the credit scores consumers see when they request their credit reports will be different from what lenders see and use when making credit decisions, research suggests there isn’t too much of a functional difference. Specifically, research from the CFPB which studied 200,000 credit files across the three credit bureaus – TransUnion, Equifax and Experian – found that for the majority of consumers the scores produced by different scoring models provided similar information about the relative creditworthiness of the consumers”³.

Armed with your credit report and credit score, lenders use both pieces of information during their underwriting process to decide first whether to move forward with providing credit to a consumer and second, in the case that they decide to provide credit, what terms to offer. The second step is important as getting approved for a loan is not the whole story, the rates offered can vary significantly depending on your credit score. This is especially important for larger credit extensions such as mortgages. Getting a mortgage rate that is 1.0% lower can result in very substantial savings over the life of a 30 year loan. Lenders use credit scores to determine whether to approve credit extension and to decide how much to charge consumers for credit.

The Difference Between Soft and Hard Inquiries

These are two important terms that everyone should understand. The credit bureaus have two major categories of inquiries when it comes to credit scores: ‘hard’ inquiries and ‘soft’ inquiries. Hard inquiries are the result of new applications for credit, such as a mortgage loan, bank accounts and credit cards. Hard inquiries do appear on credit reports for Lenders and do have an impact on credit scores. Soft inquiries are the result of other business reasons that don’t have to do with new credit extension, and includes opening new accounts with utility or cable companies and employment-related credit inquiries. Soft inquiries do not appear on credit reports that are sent to lenders and do not have an impact on credit scores. This is a summary of 8 different types of credit inquiries to help with distinguishing between soft vs. hard credit inquiries:

With the prevalence of Buy Now, Pay Later (BNPL), which is itself a form of credit extension, many have asked whether taking advantage of this payment method impacts their credit. In most cases it does not and many BNPL providers will either forgo performing a credit inquiry entirely or perform a soft inquiry to pre-approve you for the service.

How many inquiries do people make on average? To answer this we found research from the Consumer Finance Protection Bureau which examined consumer financial records in the U.S. over many years and showed that consumers on average had 4 hard inquiries over this period⁴. Consumers with higher average credit scores (greater than 750) on average had only 2.5 hard inquiries over the period. Keep in mind that inquiries remain on your credit report for 2 years, and so these are rolling measures. In fact, in the computation of your credit score FICO only considers inquiries from the preceding 12 month period.

What is a Good Credit Score? What is a Bad Credit Score?

The above diagram shows the range of credit scores for Experian along with how the credit bureaus categorizes them. On the right side of the diagram it shows the percentage of the United States population that has a particular range of credit score. This is how various credit score ranges are considered from a consumers perspective. The lowest credit score a person could have is 300 and the highest is 850. According to Experian, 67% of people in the United States have a credit score that would be considered “good” or better. But is this consistent with how lenders think about credit scores?

How Lenders Think About Credit Score Ranges

The diagram above shows the credit score categories from Ally Bank’s automotive lending business. The numerical categorization is completely different as is the actual language. But whenever you hear banks and credit unions talk about the “prime rate” now you have some context on what exactly prime means and why it is viewed as the benchmark.

Credit scores are not fixed statistics and tend to fluctuate over time as people’s activities change. Indeed, over time the average credit score in the United States has actually been increasing:

This suggests that while credit scores are relative measures, they aren’t entirely relative measures and as the U.S. consumer’s financial situation in aggregate improves, the average credit score will also improve. While there are minor variations in how FICO and the different credit bureaus calculate credit scores, they tend to be fairly similar. It is unlikely that you have an “exceptional” credit score with one credit bureau and a “poor” credit score with another. So we’ve answered what a good vs. great vs. poor credit score is numerically, but what does it actually mean in practice? These are a handful of the types of credit scores you’ll need to access certain services:

• 500 Credit Score – minimum for FHA Loans with a 10% down payment
• 580 Credit Score – minimum for FHA Loans with a 3.5% down payment
• 600 Credit Score – this is the recommended minimum to get approved for renting
• 620 Credit Score – recommended minimum to get approved for a mortgage
• 640 Credit Score – this is the minimum score needed for a USDA loan
• 660 Credit Score – this is a key threshold for credit card approvals
• 700 Credit Score – this is the minimum needed to get approved for a jumbo mortgage

Another way to look at different credit scores is in score bands e.g. in the subprime category will be 500-540 credit scores in the lower half and 540-580 credit scores in the upper half.

Statistically speaking, the credit score needed to buy a house (or other property) in the United States is 620. This is based on loan origination data that shows that 98% of mortgages that were approved in the U.S. in 2021 were for consumers that had credit scores above 620. For pretty much every other kind of credit there are no hard and fast rules.

These credit score ranges raises the question of whether a 750 credit score is all that one needs. We spent time researching this question and ultimately we think that for the vast majority of credit situations a 750 credit score will be enough to get approval. But as we said earlier, that’s not the end of the story as you still should be looking for the best possible rate and your credit score is a major determinant of that. A person with an 800 credit score is likely to get a more attractive mortgage rate than a person with a 750 credit score, all else equal. In short, a 750 credit score is “very good” as Experian would describe it, but we’d recommend continuing to employ best practices to build your score.

How Much Do Credit Scores Change Over Time?

This is an especially important question because of how common it is for credit repair companies to claim that they can, for example, improve your credit score by 100 points overnight. The simple fact is that these claims are exaggerations and often simply not possible. For this reason, CFPB has for years issued warnings about credit repair companies. It is not possible to improve your credit score by 100 points overnight or in a few weeks. Credit Scores simply do not change that quickly. Earlier we outlined the relative weights of the different factors that determine your credit score. Your payment history, credit history and new credit combined are 50% of the weighting. None of these areas can change that much over a short period of time. Your payment history, credit history and new credit (which is a measure of account age) are cumulative measures and so by design cannot change by a lot over short period of time.

So for at least half of the inputs into calculating credit scores we know its unlikely that they change significantly over the short term. But don’t take our words for it, a study performed a few years ago illustrates this very point quite specifically. The study reviewed a sample of five million credit records over a 9 year period and it found that the maximum change in consumer credit scores on average was 160-170 points and this was over a 50 month period or just over 4 years⁴. Approximately 50% of the sample had a change in their credit score of less than 100 points. This should give you an idea of how long it takes credit scores to change overall. Credit Scores change slowly and it is very unlikely to see a 100 point improvement in your credit score in a short period of time.

That said, while it is difficult to improve your credit score quickly, it is quite easy to have your credit score decline over a short period of time if you fall behind on payments. Having lenders reporting delinquencies, as we discuss in the following section, can result in a substantial negative impact on your credit score. It takes time to build credit, but missteps can be costly!

How Do Delinquencies Impact Credit Scores?

What happens to your credit score if you fall behind on your credit card or mortgage payments? Clearly no one wants to find themselves in this situation and we all know that it will have a negative impact on your credit score, but how much of an impact?

The chart above summarizes results from a 2012 study and FICO research⁵. In shows three consumers with starting credit scores of 760, 780 and 680 and the expected impact to each consumer’s credit score under three scenarios:

1. Delinquent Bank Card – this is delinquency as measured by failure to pay for 30 days. This could include overdraft situations and overdraft fees that aren’t dealt with.
2. Mortgage Foreclosure or Charge-off – delinquency as measured by failure to make mortgage payments on time resulting in foreclosure.
3. Bankruptcy – this is the worst scenario from a consumer financial perspective.

The study found that being delinquent with your Bank would result in a 70-100 point negative impact to your credit score. Falling behind on your mortgage or having it enter foreclosure resulted in a larger impact of 100-150 points, and filing for bankruptcy resulted in a 140-230 impact to your credit score. So we can conclude that in the most severe of scenarios poor credit performance will hurt your score by 230 points. For a more granular look at how specific actions can impact your credit score we can use an example put forward by FICO which uses the FICO Score 9 credit model to simulate the impact of certain credit actions.

The simulation shows two consumers, one with a 607 credit score and one with a 793 credit score and shows how much their credit score would change from different credit actions. Missing a payment for 90 days (which for many financial institutions can result in a loan moving to collections) would result in a 37 point decline in the first consumer’s credit score and a 123 point decline in the second consumer’s credit score. Note how much more significant the impact is on the consumer with the 793 credit score than the consumer with the 607 credit score, from the same credit action. This is likely because with a score of 793, the probability of missing a payment by 90 days is supposed to be very low and therefore its occurrence suggests that the credit models were wrong and have to be adjusted substantially. 

A significant increase in your credit utilization (e.g. maxing out credit cards) has almost as large of an impact on your credit score as missing a payment! Further, take note of how much easier it is to hurt your credit than improve it – missing a payment for 30 days has a bigger negative impact than reducing revolving debt by 25%. Finally, as your credit score improves, the impact from negative credit actions also increases, therefore its important not to rest on your laurels and to continue enacting best practices.

5 Best Practices to Improve Credit Scores

Managing your credit history and credit scores should be a priority for every consumer because of how central of a role credit scores play in our access credit, which continues to expand each year. These are 5 best practices every consumer should employ to build their credit while avoiding several of the common pitfalls:

1. Prioritize Paying Bills – this is easily the most important best practice. We’d recommend avoiding missing payments at all costs. Setting up account alerts and auto pay are good practices that can help you avoid missing payments. As shown in the prior section, missing payments has a disproportionate impact on your credit scores and can more than offset positive behavior such as reducing your revolving credit utilization. In addition, if you fall behind on your bills and credit ends up in collections, on top of the negative impact this will have on your credit score itself, collection accounts stay on your report for seven years!
2. Some Credit Utilization Is Better Than No Credit Utilization – specifically here we are referring to revolving credit such as credit cards. FICO has stated that in some cases a low credit utilization ratio will have a more positive impact on your credit score than not using any of your available credit at all. This makes sense as lenders want to see that you can use credit responsibly and so we’d recommended using your credit cards and paying them off each statement cycle.
3. Limit Hard Inquiries and When Possible, Bundle Them – hard inquiries usually occur when we’re shopping for new forms of credit and so in many ways they are unavoidable. The credit bureaus understand this and actually have embedded in their credit scoring models mechanisms to not penalize consumers for exploring their options when shopping for new credit. Experian specifically has said that its credit scoring models combine multiple inquiries from a 14-45 day period to avoid “punishing consumers” for simply rate shopping. So we’d recommend limiting hard inquiries and when you do need to shop for new credit, do all of your rate shopping in the span of a couple weeks to limit the impact.
4. Avoid Closing Accounts Unnecessarily – closing credit accounts is a double edged-sword as on the one hand it impacts the length of your credit history and on the other hand it can also impact your credit utilization ratio. Further, if you are likely to re-open a similar account in the near future, then your credit score will impacted by the inquiry to open the account and the new account itself. While it might seem like a good idea to close an account you should only do so if its absolutely necessary because of these dynamics.
5. Keep balances low on revolving debt – credit cards are the most popular form of revolving debt and the utilization of this form of debt as detailed earlier, has an outsized impact on credit scores. In the preceding section we showed that maxing out a credit card had as large of an impact on the consumer’s credit scores as missing a payment by 90 days. This just underscores how important it is to keep credit card (and other revolving debt) utilization low. In addition to helping your credit score it is good practice given the fact that credit card debt is notoriously expensive.

Final Thoughts on Credit Scores

Employing the best practices outlined in the previous section and monitoring your credit by accessing your reports at least once a year are important steps you can take to maintain and build their credit over time. Its important to remember that as your credit score improves the more severely it can drop if you have negative credit actions, all the more reason to establish and maintain great financial habits.

Sources

¹ CFPB, Key Dimensions and Processes in the U.S. Credit Reporting System

² This data we accumulated from the HMDA database for the year 2020

³ Analysis of Differences between Consumer- and Creditor-Purchased Credit Scores, CFPB 2012

⁴ Timing of Applications for Consumer Credit, CFPB 2019

⁵ VantageScore: Sara Davies, Introduction to the VantageScore Model, Ways Consumer Credit Scores Are Impacted and Methods for Score Improvement, Presentation at the Symposium on Credit Scoring and Credit Reporting at Suffolk University Law School (June 6, 2012).