How is a credit score calculated?

In today's fast-paced, modern world, credit scores play an even more critical role in the different aspects of your financial life. Whether you're on the hunt for a new apartment, need a new credit card, or are applying for a loan, lenders and financial institutions check your credit score as a part of the approval process.

You may be wondering how a number can wield so much power. But a credit score isn't just any number – it's a number ranging from 300 and 900 representing how financially responsible you are. Credit scores are calculated by Equifax or TransUnion in Canada and help lenders assess how likely you are to pay back credit.

Your credit score could help you access lower interest rates and insurance premiums and is a major factor in getting approved for a mortgage. But do you know how your credit score is calculated? Let's look at the different factors used to calculate it and how you can improve your credit score.

What are the main factors used to calculate a credit score?

The main factors used to calculate a credit score are payment history, credit utilization, credit history, types of credit, and credit inquiries. Each factor makes up a different percentage of your credit score, with some factors weighing significantly more than others.

It's important to note that if you check your credit score with Equifax and TransUnion, you may see different scores – which is completely normal. Both credit bureaus use multiple scoring algorithms, and when lenders make decisions, they usually only request one score. While all score versions share the same purpose, like predicting if you'll pay your bills on time, score calculations do have some differences. That said, here is a general breakdown of the factors the credit bureau’s scoring models use.

Payment history – 35%

Your payment history makes up 35% of your credit score – the most out of all the factors. This factor considers how well you pay your bills on time, missed payments, and days overdue.

Late payments of over 30 days will typically be reported on your credit report, and will lower your credit score. How delinquent your payment is, the number of accounts that have late payments, and whether you’ve made those accounts current all play a role. When you make your payments on time, your score will increase, but everytime you miss a payment, your score will be negatively impacted.

Tip: If you can’t make on-time payments, even just making the minimum payment on your credit card balance will help you avoid getting dinged.

Credit utilization (how much credit you're currently using out of what's available to you) – 30%

Your credit utilization – or how much credit you're using out of what's available to you – contributes 30% to your credit score. It considers the total owed, the types of accounts you have, the number of accounts you have, and much you owe in relation to your available credit. You can calculate your credit utilization by dividing your total credit card balances by your total limits and multiplying by 100. For example: if you have a total credit card balance of $2,000 and a total credit limit of $10,000, your credit utilization would be 20%.

Having large balances can lower your score, but having small balances may help increase your score because you're demonstrating responsible credit usage to lenders. Also, it’s important to note that new loans with limited payment history may temporarily lower your credit score, but loans that are close to being paid off may raise it because they demonstrate good payment history.

Tip: The credit bureaus recommend keeping your utilization ratio under 30%.

Credit history – 15%

The length of time your credit accounts have been open accounts for 15% of your credit score. The longer your history of making on-time payments, the better your score will be. Credit score models consider the average age of your credit accounts when looking at your credit history, and it’s best to keep them open and active. Although it may seem counter-intuitive, it's best to use your credit cards and pay off debt as you go because it can harm your score if lenders don't have enough credit history to evaluate.

Tip: Keep your oldest credit card account open, even if you don't use it as much as your newer accounts. Your credit history will be shortened if you cancel it.

Types of credit – 10%

The types of accounts you have make up 10% of your credit score. A mix of accounts, like installment loans, mortgages, and credit cards, can help improve your credit score. Demonstrating that you can use credit responsibly will showcase your ability to handle different types of financial products, and can positively impact your overall creditworthiness.

Tip: Did you know there are two kinds of credit – revolving and installment? Revolving credit allows you to borrow up to a limit and repay it flexibly, like credit cards and lines of credit. Installment credit, such as car loans or mortgages, provides a specific loan amount that you repay in fixed monthly installments over a set period of time. It's a good idea to have a mix of both types of credit to demonstrate you can handle both.

Credit inquiries – 10%

Whenever a bank or lender checks your credit file, it’s recorded as a credit inquiry. Hard inquiries (also known as hard pulls) impact your credit score and will show on your credit report. When you check your credit score yourself, it's known as a soft inquiry (or soft pull) that won't show on your credit report. You can check yourself with a free service like Borrowell, or when you sign up for KOHO’s Credit Building tool and monitor your credit score on our app.

Too many credit inquiries on your report could signal that you're in financial trouble because it looks like you're rapidly trying to secure new credit. If your credit inquiries are for different purposes, like a loan and a line of credit, they will slightly impact your credit score.

Tip: The "credit pull window" groups multiple inquiries for the same purpose as one inquiry, typically if they’re all within 14-45 days. For example, if you're shopping around for the best mortgage rate, the window will prevent your credit score from being impacted multiple times.

What are the benefits of having a good credit score?

Having a good credit score (between 660 and 724), makes it easier to access better financial products, and save you money. Here are the top three advantages:

Higher credit limits

Lenders may be willing to lend you more because your credit score shows that you’re responsible with credit. If you have a good credit score, you can apply for a higher limit on a new account, or an increase on a line of credit.

Lower interest rates

When lenders see you pay bills on time and manage credit well, you should be able to access lower interest rates. This means you can save money on interest payments over time.

More purchasing and negotiating power

If you’re shopping around for a new car or home, being pre-approved by lenders gives you an edge – especially in competitive markets. When you have a good credit score, you could have leverage to negotiate prices, and close deals faster than someone without a pre-approval.

How can I improve my credit score?

Now that you know how your credit score is calculated, you can take the necessary steps to improve it. Making your payments on time and keeping an eye on how much credit you're using compared to how much you have available should help you improve your credit score.

If you're looking to build your credit history, KOHO's Credit Building helps you securely establish your credit history. When you provide some information, we'll perform a soft credit check and issue a balance accordingly. Each month, KOHO will report a small repayment amount to the credit bureaus, helping you build your credit history. Plus, you can track changes to your credit history using KOHO's app, making monitoring your credit score a snap.

Remember, improving your credit score takes time – but with patience and diligence, you'll be on the right track to taking charge of your financial well-being.