How Are Credit Scores Calculated?

One of the first questions people ask when learning about award travel is whether opening many credit cards hurts your credit score. The answer is NO. In fact, opening additional credits can even help your credit score! To understand why, we need to understand how credit scored are calculated.

What Is a Credit Score?

Many different forms of credit scores exist, but most banks rely on a consumer’s FICO credit score or some near variation of that score. As such, we will focus on FICO credit scores. The three main credit reporting agencies–Equifax, Experian, and TransUnion–each report your credit score, and they each calculate credit scores slightly different from the other.

We will show how credit scores are calculated further below, but first, what is a good or a bad credit score? Here’s how credit scores are typically broken down by quality:

800-850: Exceptional

740-799: Very Good

670-739: Good

580-669: Fair

300-579: Very Poor

Credit Score Calculation

Many factors go into calculating your credit score, with some factors playing a bigger role. Here is how credit scores are generally calculated:

Payment History

Failing to make a loan payment, such as on a car loan, credit card bill, or student loan, shows up on your credit. The longer and more recent the delinquency, the greater the negative impact on your credit score. Even if you get up to date on your payments the following month, that delinquency will remain on your credit for seven years. At 35% of your credit score make-up, one missed payment can drop your credit score by dozens of points.

Making a payment on time only requires you to make the minimum payment due. However, you should always avoid carrying a balance on your credit cards because you will still be charged interest, even if you make the minimum payment.

Credit Utilization

Also known as debt-to-credit ratio, this means the relative size of your current debt. This is the total amount of your debt divided by the total amount of credit that you’ve been extended across all accounts. There is no magic number for what your debt-to-credit ratio should be, but you don’t want it to be high. A high credit utilization suggests that you are close to spending more than you can afford, or that if an unexpected financial emergency happened, you might fall behind on your existing payments.

To keep your credit utilization low, you can try setting up balance alerts to notify you if you’re coming close to maxing out your credit line on any one credit card.

Unlike with payment history, credit utilization is easier to fix. Once you pay a high balance that frees up your credit line and the card-issuing bank reports that payment to the credit bureaus, the effect disappears from our credit score. 

Credit History

This is the average length of all accounts on your credit history, including credit cards, student loans, car loans, mortgages, etc. This becomes a significant factor for those who have very little credit history, such as young adults or someone who just recently moved to the U.S. for the first time. It can also be a factor for people who open and close accounts within a very short period of time. Old accounts show lenders that they can count on you as a long-time customer.

One way to boost this aspect of your credit score is to become an authorized user on someone else’s credit card. The effect of this is that your credit score will reflect that you have had a credit card open since the principal user first opened his or her card. For example, if one of your parents opened a credit card in 1997 and you become an authorized user in 2020, your credit score will reflect the fact that you have had a card opened since 1997, even though you are only an authorized user.

Credit Mix

This relates to the different types of credit accounts you have, such as mortgages, car loans, credit cards, and student loans. While having a greater mix of types of loans is better than having fewer, we are not recommending that you take out unnecessary loans just to boost your credit score.

Credit Inquiries

This relates to when lenders pull your credit to decide whether to grant you a new account or a loan request, such as a car loan or mortgage. Your credit score can drop a few points each time someone pulls your credit, but it recovers quickly within a month or two.

Having too many inquiries all close to each other can also affect your credit a bit. But credit inquiries play such a small role in your overall score that this is not a cause for concern usually.

However, keep in mind that checking your own credit score does not affect your credit score. 

Why Does Opening Credit Cards Help My Score

Over two-thirds of your credit score is based on your payment history and credit utilization. Opening new credit cards does not affect your payment history and it contributes to your credit utilization because it increases the amount of credit available to you.

Let's walk through an example of how this works.

Say your monthly expenses are $5,000 and you have one credit card with a $5,000 credit limit. Each month, you put all your expenses on that card and pay it off in full. Your payment history is excellent because you never miss a payment. But your credit utilization is not very good at all because you are using 100% of your credit each month. In the eyes of a lender, you won't be able to meet an unexpected expense, such as a car repair, medical bill, etc., because you're using all of your credit every month.

But say you open a second credit card that also has a $5,000 credit limit. If you continue to only spend $5,000 per month between your two cards, your credit utilization will go down to 50% ($5,000 out of $10,000). So now a lender sees you can withstand an unexpected expenses of up to $5,000.

And what if you open a third credit card? And a fourth? And you're still only spending $5,000 and making all your payments on time. Now, your credit score looks a lot better because you have a lower credit utilization.

Therefore, if you open a new credit card but your expenses remain the same, lenders will now see you spending a smaller percentage of the credit that is available to you.

Meanwhile, opening new credit cards can help broaden your credit mix, especially if you haven’t had many cards in the past. New cards can contribute to a lower average credit history, but older accounts should help offset those new cards. When you apply for a new credit card, you receive a credit inquiry, which falls under requests for new credit. This will temporarily drop 2-3 points from your credit score, though that recovers quickly.

Monitoring your Credit Score

Now that we’ve learned how credit scores work, we will discuss how to monitor your credit score and why it’s important to do so.

Since the first step to traveling on points is earning points and miles through credit card sign-up bonuses, we need good credit scores to open those new cards. Credit scores are the primary factor that banks, like other lenders, use in determining whether to grant us credit. That is why we must make sure our credit scores are healthy and our credit reports are accurate.

Several resources are available to check and monitor your credit score for free.

Banks

Many banks offer card holders free access to their credit scores. American Express allows users to view their credit scores as calculated by Experian and TransUnion. Chase and Capital One allow card holders to view their scores as calculated by TransUnion. Meanwhile, Citi is the only bank that offers card holders access to their Equifax score, for holders of such cards as the Citi Prestige, Citi Dividend, and Citi Double Cash cards. In addition, Discover offers anyone, not just their customers, free FICO scores through their Credit Scorecard.

Non-Banks

Credit Karma allows users to see both their Equifax and TransUnion credit scores for free by setting up an account. You can also see new credit accounts opened. However, Credit Karma shows you your VantageScore, which uses a different formula than FICO score, so this information will differ from your FICO score, which is what banks actually use when deciding whether to accept or reject credit applications.

Credit.com allows anyone to set up an account to view their Experian credit score every 14 days.

Obtaining Your Credit Report

In addition to monitoring your credit score, which is the number we discussed above, it is also wise to monitor your credit report. Credit reports provide your credit history, such as opened and closed accounts. Federal law entitles everyone to a free credit report every 12 months directly from each of the three big credit bureaus (Experian, TransUnion, and Equifax) by using AnnualCreditReport.com. This means you can access your credit report three times a year for free, once from each bureau. Instead of looking at all three reports once every 12 months, it is recommended to spread this over 12 months and obtain and review your credit report every four months.