All You Need to Know About How Credit Scores Work
Harrison Pierce is a writer and a digital nomad, specializing in personal finance with a focus on credit cards. He is a graduate of the University of North Carolina at Chapel Hill with a major in sociology and is currently traveling the world.Read full bio
At a Glance
Knowing how credit scores work is key to managing your financial life. Understanding what affects your score and how to keep it in good shape can save you thousands of dollars in extra interest and fees. Your credit score will determine your ability to get a loan or even rent an apartment, so it is important to know how to manage it properly. The average credit score for Americans in 2021 was 716, which is considered a good score.
Although it might seem daunting to learn everything you need to know about credit scores and how they work, it doesn’t have to be. You can take some simple steps, like paying bills on time, keeping balances low relative to the credit limit, avoiding too many hard inquiries, not canceling old accounts, and signing up for a monthly credit monitoring service. Following these steps will create a positive credit history and boost your score before you realize it.
In this article, you’ll learn:
What is a credit score?
A credit score is a numerical value that represents your creditworthiness. It is based on an analysis of your credit history, which includes information about your credit accounts, payment history, and outstanding debt. Credit scores are used mainly by lenders and landlords, but also by plenty of other groups, to assess the risk of lending money or extending credit to you.
A high credit score generally indicates a good credit history and a lower risk of default, while a low credit score may indicate the opposite. The most widely used credit score in the U.S. is the FICO score, which ranges from 300 to 850. A score of 700 or above is generally considered good, while a score of 750 or higher is considered excellent.
Classification of credit scores
You can classify credit scores into two main categories: generic and custom credit scores.
Generic credit scores are widely used and created by credit reporting agencies like FICO and VantageScore. These scores are based on a standardized scoring model and use information from your credit report to calculate your score. Because they are widely used, generic credit scores provide a consistent measure of creditworthiness that lenders and other organizations can use to assess risk.
On the other hand, custom scores are created by individual lenders for their specific purposes. They use a lender’s own data and criteria to calculate your score. They may take into account factors that are not included in generic credit scores, like job stability or income. Because they are tailored to a specific lender’s needs, custom credit scores can provide a more detailed and nuanced assessment of credit risk.
Related: Different Types of credit scores
What is your credit score made of?
A credit score consists of several key factors used to assess your creditworthiness. The specific factors and the weight they are given can vary depending on the scoring model, but some of the most common elements include the following:
- Payment history: This is one of the most important factors in determining a credit score, as it reflects your ability to make payments on time. Late or missed payments can have a significant negative impact on a credit score.
- Credit utilization: This is the amount of credit you are using compared to the total amount of credit available to you. A high credit utilization rate can indicate that you are overextended and may have difficulty making payments.
- Length of credit history: A longer credit history can indicate stability and reliability when managing credit and may result in a higher credit score.
- Types of credit: The mix of different types of credit you have, such as credit cards, mortgages, and auto loans, can also impact your credit score.
- New credit: Opening multiple new lines of credit in a short period can indicate financial instability, which may result in a lower credit score.
Related: How is your credit score calculated?
What does your credit score affect?
A credit score can impact several aspects of your financial life, including:
- Loan and credit approvals: Lenders, including banks and credit card issuers, use credit scores to determine whether to approve an application for a loan or credit. A high credit score can increase the chances of approval, while a low credit score may result in a rejection or higher interest rates.
- Interest rates: The interest rate on a loan or credit card can be influenced by your credit score. If you have a high credit score, you may be offered lower interest rates. However, the converse is also true–if you have a low credit score, you could be charged higher interest rates.
- Renting an apartment: Landlords may also use credit scores to determine whether to approve a rental application. A low credit score may result in a rejection or a requirement for a co-signer.
- Employment as a co-signer: A low credit score may prevent you from being approved as a co-signer on a loan or credit card.
- Insurance premiums: In some states, insurance companies can use credit scores to help determine insurance premiums. Those with a high credit score may be offered lower premiums, while those with a low credit score may be charged higher premiums.
- Employment: In some cases, an employer may request a credit check as part of the hiring process, and a low credit score may impact the hiring decision.
Why do lenders use credit scores?
Lenders use credit scores to assess how risky you are as a borrower. A credit score provides a snapshot of your credit history, including information about your payment history, outstanding debt, and credit utilization. By taking this information into account, lenders can determine how likely you are to repay the loan or credit on time.
For example, a person with a high credit score is considered a lower risk because they have demonstrated a history of making timely payments and managing their credit responsibly. On the other hand, a person with a low credit score may be seen as a higher risk, as they may have a history of missed payments or overextended credit.
By using credit scores, lenders can make more informed lending decisions, which can help them avoid losses from default or late payments. This benefits not only the lender but also the borrower, as it helps to ensure that credit is extended only to those who can repay it.
A good credit score varies depending on the model used to calculate it, but generally, a score of 700 or above is considered a good credit score.
For the most widely used credit scoring model, the FICO score, a score of 700 or higher, is considered a good credit score and can help you obtain credit at favorable terms. A score between 670 and 739 is considered a “fair” credit score, while a score below 670 is considered a “poor” credit score.
Learn more: What is a good credit score?
There are several ways to check your credit score:
- Free credit report: You are entitled to receive one free credit report per year from each of the three major credit reporting agencies: Equifax, Experian, and TransUnion. You can request your free credit report at AnnualCreditReport.com.
- Online credit monitoring services: Some online services offer free credit monitoring, which allows you to check your credit score and monitor changes to your credit report. Some popular online credit monitoring services include Credit Karma, NerdWallet, and Mint.
- Bank or credit card issuer: Some banks and credit card issuers offer credit score information as a benefit to their customers. You can check with your bank or credit card issuer to see if they offer this service.
- Purchase a credit score: You can also purchase your credit score from major credit reporting agencies or a credit reporting service.
It’s important to regularly check your credit score to ensure that the information in your credit report is accurate and to identify and resolve any errors or fraudulent activity. Monitoring your credit score can also help you understand your creditworthiness and make informed decisions about your finances.
It is not possible to have a credit score until you have established a credit history. A credit history is a record of how you have borrowed and repaid money and is used to calculate your credit score. Without a credit history, there is no information for a credit scoring model to calculate a credit score.
To establish a credit history, you can start by getting a credit card, taking out a loan, or becoming an authorized user on someone else’s credit card. It is important to use credit responsibly and make payments on time to build a positive credit history and establish a good credit score.
It is also worth noting that some credit scoring models, such as the VantageScore, can provide a score even if you have a limited credit history. This score may not be as accurate or predictive as a score based on a longer credit history, but it can still provide a starting point for those who are just beginning to build their credit.