How Credit Scores Work: The Complete Guide

Updated: Sept. 22, 2020

how does credit score work

Your credit score is a three-digit number that helps potential creditors and lenders gauge what kind of risk you pose when it comes to borrowing money and using credit. Knowing how your score is calculated and what factors influence your score can help you improve your creditworthiness so you get the best interest rates and terms on loans, credit cards, and other financial products.  

What is a credit score?

Banks, credit card companies, and other lenders use credit scores to determine what kind of risk a potential borrower poses. Before lending money or issuing a credit card, creditors want to know if a person is likely to pay their bills and handle debt responsibly

Without a credit score, it would be more difficult for banks and others to make this kind of assessment. There are a number of different credit scoring models, but most have a range that runs between 300 and 850. 

The lower your score, the more difficult it will be for you to get approved for credit. When you do get approved, you'll pay higher interest rates and receive less favorable terms. 

Conversely, a higher score means it's easier to get approved for credit. People with higher scores also get the best interest rates, and they're usually eligible for loans and credit cards that offer more perks and rewards.  

How do credit scores work?

Your credit score is a numerical snapshot that reflects how well you have used credit in the past. There are a number of data analytics companies that assign credit scores, but the most well-known — and the one used by 90 percent of lenders — is FICO (previously known as the Fair, Isaac and Company).

Companies like FICO calculate your score using proprietary algorithms that look at various data, including your credit report. There are three main companies (credit bureaus) that collect information about your credit use and publish it in a credit report. 

These three main credit bureaus are Experian, Equifax, and TransUnion. FICO and other companies analyze the information in your credit reports and use it to generate your credit score. 

Each time you take out a loan, open a credit card, or use credit, your creditors report your activity to the credit bureaus. Some of this activity carries a lot of weight when it comes to calculating your score, while other types of activity are less influential. 

Activity can stay on your credit for years, which means your past credit use can affect your credit score for a long time. This is why it's important to use credit responsibly. 

Why does your credit score matter?

Lenders and creditors may consider a variety of factors when making a lending decision, but your credit score is typically at the top of the list. A high or low score will determine two things: (1) whether you qualify for credit in the first place, and (2) what kind of interest rate and terms you receive. 

For example, someone with a very poor score may struggle to qualify for credit. This can make it difficult for them to buy a car, get a credit card, or even rent an apartment. 

The lower your credit score, the harder it is to get approved for credit, and you will pay higher interest rates that can make it tough to stay out of debt. 

Banks and other lenders want to work with people who present the lowest amount of risk. This means they market the best credit products to consumers with the highest scores.

Types of credit scores

While most people tend to think of their "credit score" in the singular, you actually have quite a few credit scores. This is because there are various scoring models.

Likewise, your score can vary among the three major credit bureaus: Experian, Equifax, and TransUnion. This is because not every creditor out there reports to all three bureaus.

Thus, your credit report might vary a bit from credit bureau to credit bureau, and this can make your credit score vary as well.

There are many different scoring models, but for practical purposes you really only need to be aware of the two major models: FICO and VantageScore.

FICO score  

The FICO score is used by more than 90 percent of lenders, making it by far the most popular scoring model. FICO has offered credit scores since 1989, and it has issued a series of credit scoring models throughout the years.

The most current FICO scoring model is the FICO® Score 9, but FICO® Score 8 is still the most widely used model

VantageScore

The three major credit bureaus created the VantageScore in 2006 as a competitor to the FICO score. Like FICO, the VantageScore has gone through a series of updates, with the most current version being VantageScore 3.0

How your credit score is calculated

How your credit score is calculated depends on which scoring model is being used. Whether it's FICO or VantageScore, the companies behind the various credit scoring models don't disclose their algorithms to the public. 

However, they publish general guidelines that let you know which factors they consider when determining your score. They also release their scoring ranges, with most scoring models falling between 300 and 850. 

In addition, they rate scoring bands or ranges from the very worst to the very best. For example, the FICO scoring range looks like this:

Source: myFICO

The VantageScore ranges look a bit different, but they follow the same general breakdown as the FICO score.

Source: Experian

Factors that impact your credit score

Each credit scoring model uses various factors to determine your score and weights these factors differently. This means that some factors are more influential than others, so it's important to know which ones matter the most. 

For example, the FICO scoring model uses five factors:

  • Payment history
  • Credit utilization
  • Credit history
  • Credit mix
  • New credit

FICO assigns different weights to each of the five factors, which break down like this:

Source: MyFICO

Payment history (35%)

Accounting for 35 percent of your FICO credit score, your payment history is the most important factor in the FICO scoring model. This factor refers to your track record of paying your bills on time. 

Because payment history makes up such a significant portion of your score, even a couple late payments can hurt you. If you're trying to repair your credit and boost your score, paying your bills on time every month is the single most helpful thing you can do.

Credit utilization (30%)

Credit utilization makes up 30 percent of your score. This is the difference between how much credit you have available versus how much you're currently using. 

You might also hear credit utilization referred to as your debt-to-limit ratio. Scoring models look at this ratio because they want to know how dependent you are on credit, as well as how much potential credit you have on hand if you need it. 

As a general rule of thumb, you should try to keep your credit utilization below 30 percent. However, it's best to get it as low as possible if you want to improve your credit score.

Credit history (15%)

Credit history refers to how long you have used credit. Scoring models calculate both the age of any individual account, such as a credit card, and the average age of all your accounts. 

This is why closing a credit card or paying off a loan can sometimes hurt your score. When you pay off an account or cancel a credit card with a zero balance, you deprive yourself of the credit history associated with that account. 

Basically, the longer you have used credit, the better it is for your score. When your credit history is lengthier, creditors get a better overall picture of your credit usage over time.  

Credit mix (10%)

Credit mix or "types of credit" refers to how many different kinds of credit you have in your credit file. Creditors like to see a healthy mix of various forms of credit because it shows that a consumer knows how to use different credit products and isn't overly reliant on one form of credit. 

For example, a person with a dozen credit cards and no other forms of credit is likely to have a lower score compared to someone with a couple cards, a car loan, a mortgage, and a student loan.  

On the other hand, you shouldn't take on a bunch of different credit types just to improve your credit mix. Rather, you should build your score by practicing good credit habits and diversifying your credit when the time is right. 

New credit (10%)

Like the name suggests, new credit is a measure of how many new credit accounts or inquiries you have on your credit report. For purposes of your credit score, only "hard inquiries" count against you. 

Every time you apply for a credit card, loan, or other form of credit, this generates a hard inquiry on your credit report. Accumulating too many hard inquiries in a short period of time can hurt your credit score because it makes it look like you're desperate for credit or can't otherwise manage your financial obligations.

This is why you should avoid applying for too many credit cards or loans at once. Instead, try spacing your applications apart by at least six months. 

Fortunately, "soft inquiries" don't hurt your score. Soft inquiries happen when you check your credit score or a lender reviews your credit profile for purposes of pre-qualifying you for a loan or credit card.   

How to check your credit

To check your credit, you need to check both your credit report and your credit score. The good news is you can do both of these things for free.

Checking your credit report

Federal law entitles you to one free credit report from all three major credit bureaus once every 12 months. You can get your free reports by visiting AnnualCreditReport.com, which is the only site authorized by the federal government to give consumers their free reports. 

The easiest way to get your credit report is to follow the prompts on the AnnualCreditReport website and download the reports online. However, you can also order your reports by mail or over the phone. 

Checking your credit score

You won't get access to your credit score when you get your free credit reports, as federal law doesn't require the credit bureaus to provide that information. However, there is still a way to get your score for free — and in just five minutes. 

You can get your free FICO credit score by signing up for the Discover Credit Score card. This is a free service offered by Discover, and you don't need to have a Discover card to sign up.  

Correcting errors on your credit report

Whether you're trying to rebuild your credit or you just want to maintain a healthy credit score, it's important to check your credit report for errors on a regular basis. This is because creditors don't always report account activity accurately, and the credit bureaus don't always maintain mistake-free credit profiles. 

In fact, a study from the Federal Trade Commission (FTC) reveals that 1 in 5 Americans has an error on their credit report. If you fail to check your report regularly, you could get turned down for credit or hit with unfairly high interest rates due to errors that shouldn't be there.

You can prevent this by reviewing your reports often and disputing any errors you find. If you see any mistakes on your credit reports, you should file a dispute with the credit bureaus.

Under federal law, the credit bureaus must investigate all disputes and respond within 30 days, letting you know they either verified the disputed item or deleted it.

If a credit bureau notifies you that it verified a disputed item as correct, you should then file a dispute with the original creditor, as creditors and lenders are also legally obligated to investigate disputed items and either provide proof they're valid or remove them from your credit report.  

5 fast ways to build credit

The good news is your credit score isn't set in stone. No matter how bad it gets you can always improve it by using proven strategies anyone can follow.

1. Pay your bills on time

It may sound obvious, but paying your bills on time every time is one of the most effective ways to improve your credit score and build good credit. Having a positive payment history lets potential creditors know they can trust you with new credit.  

If you have trouble keeping track of your bills, consider signing up for autopay. Many creditors even offer small discounts if you have your payment automatically deducted from your bank account each month. 

2. Become an authorized user

If you don't have good credit of your own you can try borrowing someone else's by becoming an authorized user on their account. For example, they can add you to their credit card so their positive payment history shows up on your credit report. 

There are a couple caveats, though. First, make sure the creditor reports authorized user activity to the credit bureaus, as not all of them do.

Second, be certain you can use the account responsibly. You don't want to get into a situation where your credit mistakes end up hurting the account holder's credit. 

3. Get a secured credit card

Having a low credit score can make it hard to qualify for a regular credit card. However, there are dozens of secured credit cards designed to help people rebuild their credit. 

While secured cards require a security deposit up front, you get this money back when you close your account or upgrade to a regular unsecured card. Some secured credit cards even offer rewards programs and decent interest rates. 

Once you get your secured card, use it to make small purchases and then pay your balance in full each month. This way you avoid accumulating interest, and you get positive payment history added to your credit report. 

4. Pay off debt 

Your credit utilization makes up 30 percent of your credit score, so it's definitely a factor you need to address if you want to build credit as quickly as possible. If you have a lot of debt, make a plan to start paying it off

Many people have success using the snowball method of debt repayment. With this method, you pick the debt with the smallest balance and work hard to pay it off as fast as you can without blowing your budget neglecting any of your other financial obligations. 

Picking the smallest debt allows you to start with a manageable debt and then pick up steam. Seeing debt disappear can be extremely motivating, giving you the encouragement you need to continue tackling the next debt down the line. 

Once you've paid off your first debt, you simply move to the debt with the next largest balance — creating a snowball effect as you pay off more and more debts. If you keep at it, you can eventually be debt-free, with a good credit utilization ratio that boosts your credit score. 

5. Get a credit builder loan

Credit builder loans let you borrow from yourself to establish a positive payment history. Rather than borrowing a chunk of money up front like you would with a traditional loan, you make payments toward a specific goal, such as $1,000 or $5,000. 

Once you have made all your installment payments, you receive the lump sum of cash plus any interest. The bank or lender also reports your payment history to the credit bureaus, which helps improve your credit score. 

Conclusion

Your credit score is a key component of your overall financial well-being, so it's important to use credit wisely and responsibly. Understanding how credit works and what factors determine your score can help you continuously improve your creditworthiness.  


About the Author


Mike Pearson

Mike is a recognized credit expert and founder of Credit Takeoff. His credit advice has been featured in CNBC, Investopedia, CreditCards.com, Bankrate, Huffpost, The Simple Dollar, Reader's Digest, LendingTree, and Quickbooks. Read more.

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