How are Credit Scores Calculated?

Your credit score is one of the most important factors that you should consider when applying for credit. It is often the difference between being approved or denied credit, and it all boils down to three figures – which, in isolation are fairly meaningless. So, what exactly is a credit score and how is it calculated? In this article we run through everything you need to know to about your credit score and how it’s likely to affect your future applications.

What is a credit score?

Your credit score is a three digit number that tells banks and lenders how likely you are to repay debt based on your credit history. It’s used to decide whether to approve you for new credit or loans. The score is basically a grade of your credit-worthiness based on your past actions.

One common misconception is that your credit score is part of your credit report. It isn’t. Your score is a separate piece of information that banks and lenders use to assess the risk of lending to you. Whilst you can get a copy of your credit report for free, you have to pay to see your credit score (though we’ll walk you through a free option later on).

What affects your credit score?

There is no standardized formula for calculating a credit score, and every credit bureau does it slightly differently. No matter which algorithm is used, though, they are all based on 5 core things:

  1. Your payment history. This is the most important factor in determining your credit score. If you always pay your bills on time then this will be reflected in a positive score. If, however, you miss or default on payments, or have been bankrupt, then your score will be much lower. It’s important to note that anything that can negatively affect your score will be removed over time, so you aren’t tied to a bad credit score for life if you ever have to file for bankruptcy.
  2. How you use your credit. How much of your available credit you use is the second biggest factor that determines your credit score. Generally speaking, a good credit score means using less than 30% of your available credit. So, for example, only using a maximum of 30% of the available balance on your credit card. The good news is that you can affect this right away by paying off outstanding balances. See here for our guide to budgeting for manageable debt reduction
  3. The length of your credit history. If you have a long credit history then you are essentially showing that you are a reliable borrower who is unlikely to default. If you file for bankruptcy or a consumer proposal, then your credit history will start from scratch and your history will be shorter – which will reflect in a lower credit score until you rebuild your credit which is easier than you may think.
  4. Your credit types. There are two main types of credit that you can have, which are revolving credit (such as credit cards) and term loans (such as car loans). If you have a healthy mix of both types of credit then your score will be higher. If, however, your loan mix is imbalanced (i.e. one car loan and then many credit cards), you’re demonstrating to credit bureaus that you cannot effectively manage your available funds each month, which can drive your score down.
  5. The number of credit inquiries you have. When a lender ask to see your credit report it is known as an inquiry. Though it’s not as clear cut as this, many inquiries in a short space of time indicates to the credit bureau that you are a credit risk, as you are being turned down by many lenders. The inquiries that have the biggest impact on your score are those made by employers, utility companies or banks. Asking to see your own credit record won’t affect your score.

There are a few other factors that can impact your score, and these mostly revolve around things that affect how easy it is for lenders to predict your risk. If, for example, you change jobs or employers often, it can send a signal that your income isn’t that stable which could affect your repayments. Frequent home moves have the same effect.

What is a good credit score?

Though their algorithms vary, both TransUnion and Equifax use a credit scoring system which will rate you between 300-900. Generally speaking, the higher your score the more likely you will be to have your credit approved at favorable rates.

Though it can be tempting to chase after the highest score, it’s not always necessary depending on the type of credit you would like to secure. Some loans, such as car loans or mortgage require high credit scores. In fact, since 2008 the federal government requires you have a minimum credit score of 600 to qualify for mortgage insurance.

However, if you simply require a credit card with a low line of credit which you intend to pay off monthly, then you are likely to be approved with a much lower score.

How to get a free credit check

While you have the right to one free credit report per year, you generally have to pay to view your credit score. It costs around $20.

However, credit bureau Equifax recently partnered with Borrowell to give you free access to your credit score. Borrowell will effectively pay the cost of your check for you, and in return they get your email address to send on financial tips. There’s no obligation to use any of Borrowell’s products or services, and you can opt out of their marketing at any time. So if you are heading up to a big purchase and want to know your score upfront, this could be a good option for you.