This, my friends, is a very complicated question, and believe it or not, with everything that is known about credit ratings and how they are established, the truth is that there is still a little bit of a black art associated with it. In order to understand how credit scores are calculated, it is important to understand the basics of credit bureaus and their rating system.
A credit bureau is basically a company that stores your personal and financial information in a database that is used to develop your credit report. The information in the credit report is used to calculate your credit rating through a credit scoring system.
There are three major credit bureau’s:
Equifax: www.equifax.com
Experian: www.experian.com
Trans Union Corporation: www.tuc.com
On each website you can find out your credit score, credit report, tips on how to improve your credit, see what actions will improve your score faster, etc. They are very informative sites and imperative to building long term credit worthiness. I recommend becoming intimately familiar with each of them.
The official name for a credit rating or credit score is “credit scoring system”. There is a mathematical formula used to determine your credit score and this score is the beginning factor used in determining your credit worthiness to a lender. The most common credit scoring system is known as the FICO score and it stands for Fair Isaac Company. There are other systems as well.
Most lenders are confident enough in the system that the number is sufficient to understand your credit worthiness. However, you can explain your credit score to some degree. Say you had a large medical bill that you paid monthly but technically you were late and it was on your credit report. Some lenders would take that into consideration.
The credit report is a record of your financial and credit activities and holds the information that determines your credit score. Since the rating system is very similar between the three major credit bureaus, people who need to establish your financial risk (creditors, landlords, etc.) will use this in their evaluation.
To the best of my understanding, the actual algorithm used to calculate the credit score is unknown. But like with anything else in life, the best way to understand it is to keep it simple: pay your bills on time = good. Don’t pay your bills on time (or at all) = bad. Bankruptcy = bad. Keep your credit card debt below 30% of your credit limit = good. And the list goes on.