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How Is a Credit Score Calculated?

By Philip Tirone

How is a credit score calculated? This is a question I’m asked often, and the answer is not a simple one. In fact, there are a lot of people who sell something they call a “credit score,” but they are actually selling garbage. This blog clarifies the players, how they work together, and what you can do to make sure that you get your hands on your true credit score.

How Is a Credit Score Calculated? The Players

Let’s start with the three main players:

1. Your creditors,

2. The credit-reporting bureaus, and

3. The credit-scoring formula.

Your creditors are those banks, lending institutions, people, and entities that report to the three credit-reporting bureaus. They consist of:

  • Banks and lending institutions that have granted you with a loan or a credit card, or that have considered a loan or credit card application.
  • People, entities, or companies that are pursuing you for unpaid debt. If you fail to pay a bill or debt, a creditor will attempt to collect this debt. For instance, you might have a tax lien or a judgment against you. In either case, a creditor will attempt to collect the unpaid money. If you fail to pay a bill, it will be turned over to a collection agency, which will attempt to collect the debt.

It is important to note that the following companies do not report information to the credit-reporting bureaus, unless you fail to pay them bills, in which case they will be turned over for collection and reported to the credit-reporting bureaus:

  • Utility companies
  • Cell phone companies
  • Landlords

Alimony and child support payments are also not reported to the bureaus, unless you fail to pay.

Now let’s talk about the three credit-reporting bureaus: Equifax, TransUnion, and Experian. Your creditors report information to one, two, or all of the credit-reporting bureaus. For instance, your Visa credit card company might report your payment history to Experian and Equifax. A bank that provided you with a small line of credit might report only to TransUnion, whereas your mortgage lender would most likely report to all three.

The credit-reporting bureaus do two primary things:

1. They collect information from your creditors.

2. They report your credit score by applying a credit-scoring formula.

So that brings us to the credit-scoring formula. Your credit score is computed using an intricate formula that considers a variety of factors.

Here is where it gets confusing. The credit-reporting bureaus apply a different credit-scoring formula depending on who is asking for your credit score.

Let’s say that you apply for a rental unit. The landlord is concerned primarily with your history of mortgage payments, as well as any evictions you might have on your record. Now let’s imagine that you also apply for a car loan. The bank considering your car loan is concerned with your history of installment payments and whether you have any repossessions on your record.

Equifax, Experian, and TransUnion know that the landlord and the car company are interested in different things, so they apply a different credit-scoring formula depending on who is asking for your credit score.

Important to note is this: 90 percent of all lenders use a credit-scoring formula called a FICO Score. None of them use something called the Consumer Score. We will discuss this in detail later. Just remember this: Of all the credit scores you can buy, the FICO score is the most important. A consumer score is the least important.

Before we get into that, let’s talk about how the players work together.

How Is a Credit Score Calculated? How the Players Work Together to Determine Your Credit Score

In summary, your creditors report to one, two, or all three of the credit-reporting bureaus. When a person or lender inquires into your credit score, the credit-reporting bureaus determine which credit-scoring formula is most appropriate. They apply the formula, and then report your credit score.

Because not all creditors report to all of the credit-reporting bureaus, the three bureaus do not have identical information. Therefore, if a bank pulls your credit score from the three credit-reporting bureaus, the bank might end up with three different credit scores. Experian might give you a 650 score, TransUnion might determine that your score is 672, and Equifax might determine that your score is 714.

The banker would ignore the high score and the low score, and just take a look at the score that falls in the middle. In this case, the bank would consider the score provided by TransUnion (672) to be your credit score.

How Is a Credit Score Calculated? Getting Your Hands on the Right Score

Remember a few paragraphs ago, when I told you to remember that the FICO score is the most important score, and that the Consumer Score is worthless? Let’s talk about this now.

As I’ve mentioned, the credit-reporting bureaus have a lot of different formulae they can apply to determine your score. They chose the formula based on who is asking for your credit score.

If you pull your own credit report and buy your credit score, most often, the Consumer Score will be applied. This is a generic credit score that no lender, landlord, or employer will ever use. Only the consumer sees a Consumer Score.

In this way, the Consumer Score is worthless. And unfortunately, it is often a lot higher than a FICO score. This means that if you buy your credit score from most places online, you will receive a Consumer Score that gives you an artificial sense of security about your credit score.

Almost all lenders use a FICO score. If you buy your credit score, make sure it is a FICO score so you have an accurate idea of where you stand. A consumer can buy FICO scores from both Equifax and TransUnion at www.720FICOScore.

However, Experian does not sell FICO scores to consumers. If you want to see all three scores, a lender will have to pull your credit score. The benefit of this is that you have all three scores. You can ignore the high score and the low score, knowing that the middle score is the credit score a lender would use to determine your interest rates.

The downside of getting your credit score from a lender is that a hard credit inquiry will be added to your credit report.

How Is a Credit Score Calculated? The Difference Between Credit Scores and Credit Reports

In considering the question, “How is a credit score calculated?” I have spent a lot of time talking about credit scores. I want to make an important note: There’s a difference between a credit score and a credit report. A credit score is the three-digit number that predicts your likelihood of paying your bills on time. A credit report is a listing of all the information that was considered in your credit score.

Once a year, you can get a free annual credit report. If you want to look at your credit report so that you can identify errors, go ahead and download your free annual credit report.  However, you should never, never buy a credit score from www.annualcreditreport.com as this site sells consumer scores only. Remember that the only place to get a FICO score is from FICO itself or from your lender.

This concludes my lesson in “How is a credit score calculated?” I know this is a complicated subject, so if you have any questions, be sure to leave them in the comments!

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