Years ago, many local shopkeepers would extend credit to farmers and merchants, originating the “buy now, pay later” concept that we have all grown to know and love. Over time, an entire industry has developed around the idea of evaluating a person’s creditworthiness or ability to manage and repay debt. Thus, the credit score algorithm was born.
In today’s world, credit is an essential resource for all of us. Whether it’s a jumbo mortgage or a payday loan, lines of credit can bridge the gap between our needs and the goods and services that can fulfill them.
This fact means that when it comes to the financing of our lives, the ratings of our overall creditworthiness—our credit scores—are, well, just about everything. Depending on their quality, our credit scores can either unlock opportunities or create challenges.
If you want to make a big purchase like a home or embark on a life-changing journey like college, knowing your credit score and how it works will help you find the best financial path to take. This article will look at the ins and outs of credit scores and how understanding them can help you build great financial habits.
What Are Credit Scoring Models?
A credit score is basically a mathematical formula that compares your credit information to the data of millions of other people. It is a number that provides a general indication of your creditworthiness, created from a review of your relationship with your past and current creditors—mainly, how you manage the debt that you owe.
Credit Scores: How Do They Work?
The credit scoring models can seem complicated at first. But just about everyone knows that it’s better to have credit that’s good. However, many people don’t know where credit scores come from or who is in charge of creating them. Getting to know how credit scores work can help people with the task of managing them.
Here are the five factors that determine most credit scoring models:
Payment History (35%)
Your payment history is the record of all the on-time and late payments a person has made to their creditors. Payment history is the essential part of credit scores; it gives potential lenders clear information about your ability to repay the money that you owe. For example, when a delinquent account goes to a collection agency, that can deduct as many as 100 points from a credit score. Other issues that can affect your payment history are:
- Missing payments on a mortgage, loans, or credit cards
- Bankruptcy and foreclosures
- Being an authorized user on a credit account in lousy standing
- Settling a debt (paying a lump sum that is less than the amount owed, at the lender’s loss)
Even if you have a bad overall credit score, decent payment history can help make the difference in a lender’s financing decisions. This is why paying your bills on time is so vital to your financial health.
Credit Utilization ratio (30%)
Credit utilization is a measurement of how much of your available credit you are using at any given time. For example, let’s say you have a credit card that has a limit of $1,000. At the end of a month of spending, the balance on the card is $300. That would make your credit utilization ratio 30% (30:100).
Issues that can affect your utilization include:
- Using your entire line of credit (like maxing out a credit card)
- Refinancing a home or car loan
- Debt consolidation
The best credit scores have a credit utilization that stays at 30% or lower. Keeping at least two-thirds of your credit line readily available can show creditors that you use your credit responsibly (that is, you pay back what you owe).
Length of Credit History (15%)
A credit history list all of your credit accounts, past and current. With this record, creditors can see how you have handled your credit accounts over time, which can help make predictions about your future habits. In addition, the positive credit history of accounts in good standing will help raise your credit score.
The following things can affect your credit history:
- Not having a credit card
- Refinancing a personal loan
- Canceling credit
New Credit (10%)
Applying for a credit line or loan, or getting other credit lines (like credit cards) can potentially hurt your finances. Getting many new credit accounts can make it seem like you are in some significant financial trouble—and therefore not a good risk for a lender.
The following may affect this aspect of your score:
- Hard Inquiries (the action a lender takes to pull your credit report from a credit bureau)
- Multiple new credit accounts
Credit Mix/Types of Credit (10%)
A variety of credit accounts can show creditors that you have experience managing different types of credit. A person with a potent credit mix, for example, would have a secured auto loan with steady installment plan payments and an unsecured credit card that can have a revolving balance month-to-month. This factor has less of an impact on your score than the other factors.
The following might affect your credit mix:
- Multiple new credit card accounts
The credit bureaus determine your credit score. Credit bureaus provide credit reports on consumer spending patterns and financial habits to financial institutions and other companies. Using identifying information like your Social Security Number, these companies comb through your economic history to review all of your credit accounts.
These companies also make this data available to consumers so that they can understand their creditworthiness. The three major credit bureaus reporting on American consumers are Equifax, Experian, and TransUnion. So if you’ve ever rented a home, bought a car, or applied for a credit card, each of these agencies has a credit report on you.
Using the five determining factors listed above, the credit bureaus analyze the activity detailed in your credit report and calculate your credit score. This number is your FICO score. While lenders can use several different credit-scoring models, FICO scores (named for the company that created it, Fair Isaac Corporation) are the financial industry’s standard measurement to determine loans and lines of credit. FICO Scores are calculated as three-digit numbers that range from 300-850. The higher the number, the better your creditworthiness:
- 300–499 Very Bad Credit
- 500–600 Bad Credit
- 601–660 Fair Credit
- 661–780 Good Credit
- 781–850 Excellent Credit
Types of Credit Scores
Although it sounds like a singular number, you have several credit scores—each credit bureau that runs a credit report on you will have its unique score. When a potential lender runs a credit check, they aren’t required to submit your application to all three bureaus, which means that things like hard inquiries can affect one credit score but not the other.
And since these scores come from different companies, there is no universal schedule they follow regarding updating. That means that both positive (paying down credit accounts) and damaging (late payments) efforts can be reflected at varying times across each credit bureau’s score.
Credit scores are used by lenders, credit card companies, and other financial institutions to help them decide if they want to do business with you. Your credit score will determine whether they will work with you and the terms of any loan agreement they have with you. A higher credit score, for example, indicates a strong history of on-time repayment. That means that the risk that a borrower will default on the loan is low so that they could receive a loan with a low-interest rate and longer repayment terms. On the other hand, a lower credit score indicates a higher risk of default. This means that even if they are approved for a loan, a borrower with bad credit will most likely pay higher interest rates under tighter loan terms.
Know Your Credit Report
One of the reasons your FICO score might be lower could be found among errors in your credit report.
Carefully managing your credit is difficult enough; you don’t need incorrect information on your credit report causing unnecessary damage to your overall credit score.
Credit report errors could include:
- Closed credit cards or settled accounts still listed as open and with balances owed
- On-time payments listed as delinquent
- Incorrect credit limits and balances listed
- Unauthorized credit inquiries and performances due to identity theft
- Incorrect ID information (misspelled names, incorrect addresses, etc.)
Credit Report Errors
Regardless of all the supporting technology and algorithms used to calculate credit scores, no system is perfect. Instead, humans manage the information put on it, which means that credit report errors can and do happen.
You must review your credit report against your financial records to determine if there are any credit-damaging errors. If an error is found, a consumer can file a challenge to verify the form, called a dispute. Disputes filed with Equifax, Experian, and TransUnion are typically resolved within 7-14 days and available to anyone.
Even after you find and resolve any errors on your credit report, a diligent review of your credit report, every few weeks will avoid you missing future errors or even being hit with the same mistake reappearing on your account. In addition, there are tons of apps and online services, like creditsesame.com, that will give you free access to your credit score, credit report and provide assistance in filing disputes.
As you go over your credit report, you may come across an item or delinquent account that is, in fact, your responsibility. However, thanks to the Fair Credit Reporting Act, there are limits on the time any given piece of negative information can stay on your credit report.
It is not just enough to know your FICO score. To help you stay out of debt, It is critical to understand the factors that create it and how each of them can be affected by the financial choices you make every day.
Bad credit doesn’t have to stay with you forever. There are steps that you can take right now that can move your credit score up and give you access to better financial services. However, the work starts with you.
Awareness is one of the big problems that people face when it comes to managing their credit health. When they don’t know specifics, people tend to assume the worst—particularly when it comes to finances. If you are struggling with bad credit, or don’t even know if you’re in trouble, visit the major credit bureaus online today. Once you harness the power to discover and improve your FICO score, you will most likely learn the two things that most of the financially enlightened out there already know:
- It’s not as bad as you thought.
- With time and effort, it will get better.