What is a Credit Score and How Does it Affect You?
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When lenders are reviewing applications for loans or credit cards, they want a simple way to tell if you will pay back the money you borrow. For that, they look at your credit score. This three-digit number represents how well you manage your money, and it can have a significant impact on your family finances. Your credit score can determine whether you are approved for a loan and how much interest you pay.
Landlords may even check credit scores and credit history when deciding whether to approve a rental application. If you’re wondering how one number can be used for so many important decisions, keep reading for everything you need to know about what credit scores are and how they are calculated.
Your Credit Score: The Basics
While there is a lot to unpack about credit scores, these are the essential points you need to understand.
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Credit scores are calculated using formulas that include factors such as how much you
owe and whether you pay on time. -
Multiple companies create credit scores, but those from FICO and VantageScore are
most used by lenders.
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Scores usually range from 300-850, with higher scores meaning better credit and more
favorable lending terms.
How Your Credit Score Is Calculated
You don’t have one single credit score. Instead, you have many credit scores, and each has its own formula.Still, they all look at roughly the same general factors using data from your credit report. For example, here is how FICO weights these factors for its general scoring model:
Payment History
This is often the most important factor in all credit scoring models. Payment history refers to whether you pay your bills on time or have late or missing payments. It also reflects whether you have delinquent accounts in collections or filed for bankruptcy.
Amounts owed
Credit scoring companies look at how much you owe compared to your credit limits. Known as a credit utilization ratio or rate, the percentage of credit you use should ideally be below 30%. For instance, if you have a combined $1,000 limit on all your credit cards, it’s best not to carry more than a $300 balance. Having a high credit utilization rate can indicate you are overextended financially and drop your credit score.
Length of credit history
Typically, a longer credit history is better for your credit score. That’s one reason many experts advise against closing unused accounts. In addition to the age of your oldest account, a credit score may also take into consideration the age of your newest account and the average age of all your accounts.
Credit Mix
This refers to the different types of debt you might carry. That’s one reason many experts advise against closing unused accounts. In addition to the age of your oldest account, a credit score may also take into consideration the age of your newest account and the average age of all your accounts.
New credit
Opening several new accounts at once can drop your credit score. It can signal that you are in financial trouble now or could be shortly in the future. Even if you don’t open a new account, applying for credit cards and loans results in “hard inquiries” on your credit report that can reduce your credit score. Not all credit scores will weight these factors the same as the FICO percentages above. In fact, FICO itself has many scoring models that are designed specifically for certain types of lenders, such as those offering auto loans, mortgages or bankcards.
Who Decides Your Credit Score
Two companies create most scores used by lenders today.
VantageScore
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Created in 2006 by the three main credit reporting
companies, VantageScore is an alternative to FICO.
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VantageScore was designed to provide scores for people
who traditionally haven’t been eligible for a FICO score.
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For instance, while FICO requires someone have an
account open for at least six months to receive a credit score, VantageScore can issue a
one after an account has been open only one month.
FICO
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Previously known as the Fair Isaac Corporation, FICO
is the company that created the first credit score in 1989.
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Prior to that, there was no standard way for lenders
to gauge the creditworthiness of an applicant.
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Today, FICO scores are the most commonly used scores
for lending decisions.
To create their scores, FICO and VantageScore rely on data from the three major credit reporting companies:
Equifax
Experian
TransUnion
These companies collect data from lenders to create credit reports. Each report lists what accounts you have open, whether you have made timely payments, and whether any debts are currently in collections.
How Credit Scores Work
Using data from the credit reporting companies, FICO and VantageScore create scores that range from 300 to 850. Depending on the number, your credit may be deemed poor, fair, good, very good or excellent. According to Experian, here’s how each company’s scores break down:
These are just guidelines though and what one lender thinks is a good score may vary from how others define it. Lenders often use credit scores in conjunction with other information when making decisions. For instance, they may also consider your income and employment history.
Why Are My Credit Scores Different?
If you check your credit score through various websites, you might see that the number can vary. There are three reasons for this:
It is up to lenders to report information to credit bureaus, and some don’t report to all three. As a result, your credit report from each company may be different and that could result in a different credit score depending on which report is used. FICO creates different scores based on each credit report.
You have three FICO scores for each of its models: one based on your Equifax report, one based on your Experian report and one based on your TransUnion report.
The latest version of VantageScore – VantageScore 4.0 – is the first “tri-bureau” credit score. That means it incorporates data from all three major credit reporting companies into a single score.
Tour credit score is based on a snapshot of your finances at any moment. A score that is calculated before you make a monthly payment, when the balance on an account is higher, may be different than the score you will see after that payment is reported.
Why Does a Credit Score Matter?
A low credit score can cost you money and opportunities. Lenders and others who have access to your credit score make decisions based upon it. If your score is low, lenders may think you are likely to default on payments, so they charge a higher interest rate to offset that risk. Consumers with high credit scores are seen as reliable customers and rewarded with low interest rates to encourage their business. Watch your credit reports for any errors that could unnecessarily reduce your credit score.
By law, you are entitled to one free credit report annually from each of the three credit reporting agencies. You can request these from AnnualCreditReport.com, the only official website authorized by the agencies. If you find something incorrect, follow the company’s instructions for disputing information to ensure that it doesn’t negatively impact your credit score.
