Credit Scores: What are they? How do they work?

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A credit score is a number that third parties, especially lenders, use to assess the risk of lending you money. The score is one way banks, credit card companies and other institutions assess the likelihood that you can or will be able to pay off any debts you accumulate. A higher credit score indicates that your current financial circumstances and your historical behavior demonstrate a willingness and ability to pay off any loans you may be approved for.

In the United States the credit scoring system you will hear about most is the FICO score, a score used by the major credit agencies to rate your creditworthiness. Your FICO score will be between 300 and 850 with a higher score being better. When it comes to your credit, lenders may sometimes refer to it in terms of Credit Level or Credit Quality such as Poor, Fair/Average, Good or Excellent with each category referring to a range of FICO scores.

  • Poor credit is considered anyone with a FICO score under 630
  • Average or Fair credit rating will be between 630 and 690
  • Good Credit is between 690 and 720
  • Excellent credit is anything above 720

How Your Credit Score Impacts Some Financial Products

Your credit score can have an effect in two ways: Whether you can get approved for a financial product in the first place, and what interest rates you may have to pay if you are approved. The higher your FICO score the more likely you are to get approved for a credit card or loan, and will usually reduce the interest rate associated with that particular loan or card. Lower scores may disqualify you for a product or service completely and can raise your interest rates significantly otherwise.

For many credit cards, especially the most lucrative rewards cards, the cards are offered only to consumers that meet a minimum credit quality. Many of the best cards are exclusively marketed to consumers with excellent credit scores. When it comes to credit cards your credit score can determine the breadth of options you can choose from. Most cards are also marketed with a range of interest rates/APRs. The actual interest rate on your specific card will be inversely related to your credit score with higher creditworthiness receiving lower interest rates and vice versa.

With mortgages and auto loans, lenders behave similarly. Your credit score is used as a component whether or not a bank will choose to approve a loan or may force you to make additional concessions for approval. It can and generally will move the interest rate you pay on the loan as well.

The Components Of Your Credit Score

The makeup of your FICO score is broken up into a bunch of major factors: Payment History (35%), Debt Burden (30%), Length of History (15%), Types of Credit(10%), and Recent Credit Searches(10%). Let's take a look at how these components fit in to creating your overall credit profile.

Stacked Chart of Credit Score components

Payment History

Your payment history is by and large the largest single component of your FICO score. The best way to think of your payment history is to consider it a track record of all the things you've done wrong when it comes to credit and a measure of how you behave when it comes to your debts. You don't get a boost for paying things on time as much as you get penalized for not doing so. A history marked with negative information would indicate that the person often faces difficulty meeting their debt obligations, or rather someone that has a risky attitude when it comes to their credit. Both are signals to the lender that they may want to be more cautious when it comes to making additional credit available.

Late Payments

The most common problem consumers face in the payment history component is late payments. Whether it was because you simply forgot or were struggling to make ends meet, being late on a monthly payment for your credit card or a loan will usually cause a negative adjustment on your credit score. How much of an impact can also depend on how late you were with the FICO score making larger downward adjustments the later it is. You will see this reflected on your credit report with late payments marked under categories like 30-days or 60-days etc. One thing to be aware of is missed or late payments on what may seem like trivial amounts can be just as damaging.

One major reason for keeping the number of credit cards and accounts you have at a manageable level is to avoid these issues. It's way too easy to open up a store credit card, make a charge on it and simply forget about the account. Even if you're making thousands of responsible payments on all your other accounts, forgetting to pay off the $50 you spent on that one off charge can dramatically hurt your credit score.

Debt Burden or Accounts Owed

The other major component category of your credit score is the break up of your existing debt burden including how much you owe in total, what types of loans you have and any other quantitative indicators about your overall debt/credit profile. As an indicator of your creditworthiness how much you owe and how it's broken up across the different types of loans acts as a signal about your capacity to manage your existing debt.

When it comes to how this plays into your credit score, it's probably not worthwhile to think of it was higher/lower = better. In all likelihood, the FICO calculation doesn't evaluate your debt burden in isolation but considers it in relation to things like your payment history. For instance, let's consider a credit profile of someone who has large amounts of debt but a long and spotless payment history. This might indicate that the person is financially well off and the debt burden is a signal that any additional loans might be obligations they can easily handle.

Take the same level of debt on a profile with a recent history of payment problems, and the higher quantitative factors should be a major red flag. This consumer may be having difficulties making ends meet and even a small amount of additional credit might be a risky proposition.

Credit Utilization

Credit Utilization or Debt to Limit ratio is often brought up when discussing the Debt Burden component. It is one of the pieces that make up this piece of your FICO score and is a measure of the total amount of debt on your credit card accounts against the total limit allowed on those accounts. A lower credit utilization, meaning your average balance is lower relative to the total amount you could have on your cards is better for your score.

This ratio can come into play when you might otherwise consider canceling an existing credit card. Even if you don't use that card, as long as it doesn't have any fees associated with having it around, your credit utilization figures look better because of the larger total credit limit overall. This also means that requesting a higher credit limit on existing credit cards can help your credit score since it will help lower the overall ratio.

I suspect that the reason this measure is used as a factor is that it's a helpful indicator of how much wiggle room you have when it comes to your finances. If you're only using a small portion of what the card companies have judged you to be capable of paying off, then small changes in your personal finances or incremental debt may not put you at much more risk.

Length of Credit History

Your score accounts for the length of time the various accounts under your name have been around, including the average amount across all the accounts as well as the length of your oldest open account. The length of your history helps to indicate how representative the other factors of score are about your creditworthiness. The older your accounts and your overall credit history, the larger time frame from which a company can accurately judge both your finances and behavior towards credit. A few years of data about a consumers is a better indicator for how they may act in the future than having only a few months of information.

Considering Age of Account When Canceling Cards

The credit history length can come into play when considering how you should deal with something like an old credit card. In many cases the first credit card a consumer gets may no longer be the best option going forward. This is often the case for someone that may have had no credit history to speak of when getting a card and have over time built a great credit history for themselves.

Types of Credit

The smallest component of your credit score, your FICO score takes into account the different types of debt or credit used. Your accounts are classified into things like revolving credit (credit cards), mortgages, consumer finances or installment loans and a history of having a broader exposure may be a positive signal. Why should having a history with more credit types matter? Having an existing history of exposure to different types of credit is a helpful indicator that a consumer is familiar with the different financial products and can manage them appropriately. Consumers also may not have the same attitude towards paying off a credit card vs. their mortgage so a lender might want to be more cautious with someone with a narrower exposure history.

Much like the Length of history component, the types of credit component is likely used as a measure for how representative your existing credit history sample size will be about your future behavior. A broadly representative history will in most cases be a better predictor of how a consumer will act in the large range of credit situations in the future.

Recent Credit Searches

The last component of the FICO score is an adjustment based on any recent searches or hard inquiries made into your credit profile. This tracks the number of times lenders have requested your data, with the potential for a consistent high number of request to drag your score down.

The FICO score calculation does make a number of adjustments in how it evaluates the number of inquiries however. When it comes to mortgages, auto loans, and student loans it's expected that most consumers will shop for rates at a large number of lenders so all searches of these types that occur within 14 to 45 days of one another are considered a single request. These inquiries also take 30 days before they affect your score so that you will be evaluated fairly while rate shopping. These adjustments mean that consumers seeking a loan are best served it they compress the time in which they rate shop, such that they have the least amount of impact on their score overall.

Lastly, consumers often under go credit score queries for reasons other than getting a loan. This may include checking your own credit score, or a requirement as part of employment. In these cases, the queries are not considered a hard pull/inquiry and will not appear on the reports used by the lenders for evaluation.

Why You Have Three Different Credit Scores

Given the above components for your credit score, why do consumers have three different scores? This is because there are three different credit bureaus that independently calculate your score: Experian, Equifax and Transunion. While the three companies use very similar processes for determining your credit score, they there are small differences in how they're done. Another complication is that the three bureaus may not all have the same information on you in their systems when making these determinations. This often occurs when an account in your credit history has been reported to one bureau but not another.

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