Credit scores are typically generated by three credit bureaus: Equifax, Experian, and TransUnion.
These bureaus receive credit related information from companies you do business with, and produce a credit rating. Although the exact formula is proprietary, we do know that it is based on the following factors.
1. Payment History (i.e. do you pay your bills on time). This factor is the most important of all if you want to have a good credit score. The payment history will indicate to the credit bureau how recent your late payments are, how severe they are, and how frequently you are late.
Credit bureaus love people who pay on time all the time!
2. Credit Utilization (i.e. how much of your available credit do you use). You can determine your credit utilization by adding up the amount owed on all of your credit accounts, and then dividing that by your total credit limit. For example, if your current credit balance is $2,000, and your total available credit is $10,000 then your credit utilization is 20%.
The idea behind this factor is that if you are not close to your credit ceiling, then you should be able to effectively pay off your current debt.
3. Credit History (i.e. how long you’ve had credit accounts for). Credit accounts can be things such as credit cards, mortgages, car payments, a phone contract, and line of credit among other things. Essentially, if you need to get approval for some sort of loan or payment plan, then it’s considered a credit account.
Credit bureaus like to see a long credit history because it provides a good indication of how responsible you are with your credit.
4. Credit Inquiries (i.e. how often credit agencies get asked for your score for the purposes of a loan. Credit inquiries can be “hard” or “soft”. A hard inquiry occurs when you are applying to borrow money. A soft inquiry occurs when you are simply checking your credit score or a company simply does a background check on you. Hard inquiries will have a negative effect on your credit score while soft inquiries do not.
The idea is that if you’re applying for lots of loans or other credit products, then it is likely that your ability to payback all loans will be diminished in the near future.
5. Credit Portfolio (i.e. do you have different types of credit products). Credit bureaus like people who are able to successfully manage a wide range of credit products. Again, credit products can include things such as credit cards, car loans, mortgages, phone contracts etc.
The assumption here is that someone who is able to consistently make on-time payments on a lot of credit products is more reliable than someone who doesn’t have to manage as many credit products.
Some financial institutions may also have their own internal credit rating system, but they are likely based on the same set of factors listed above.