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Credit Scores: What Are They? How Do They Work?

Credit Scores: What Are They? How Do They Work?

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A credit score is a number ranging from 300 to 850 that uses a variety of financial factors to determine a consumer's creditworthiness.

Quick facts:

  • What is a credit score? A credit score is a number between 300 and 850 used to determine a person's creditworthiness.
  • How does a credit score work? A credit score influences many financial decisions, as it's used by lenders to decide whether or not to offer credit. Credit scores factor into consideration for approval of credit cards, mortgages, personal loans and other financial products.
  • Factors contributing to your credit score: These include credit utilization, payment history, accrued debt, length of credit history, past credit inquiries and more.

What is a credit score?

A credit score is a number between 300 and 850 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.

What is a good credit score?

Fico credit score ranges

  • Poor: Under 580
  • Fair: 580-669
  • Good: 670-739
  • Very Good: 740-799
  • Excellent: 800 and above

A good credit score is considered to be anything from 670 and higher. In the United States the credit scoring system you will hear about most is the FICO Score, which is 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.

Why your credit score matters

Your credit score affects:

  1. Whether you can get approved for a financial product
  2. What interest rates you may have to pay if you’re approved

The higher your FICO Score the more likely you are to get approved for a credit card or loan — plus, it’ll usually reduce the interest rate associated with that particular loan or card. Lower scores can raise your interest rates significantly, or may even disqualify you for a product or service completely.

Credit cards

Loans

For many credit cards, especially the most lucrative rewards cards, the cards are only offered to consumers that meet a minimum credit quality. Many of the best cards are exclusively marketed to consumers with excellent credit scores. And 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 and 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.

Credit cards

For many credit cards, especially the most lucrative rewards cards, the cards are only offered to consumers that meet a minimum credit quality. Many of the best cards are exclusively marketed to consumers with excellent credit scores. And 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 and 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.

Loans

With mortgages and auto loans, lenders behave similarly. Your credit score is used as a component of 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 includes several 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 into creating your overall credit profile.

The components of your credit score

Your payment history is by and large the largest single component of your FICO Score at 35%. 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 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.

The most common problem consumers face in the payment history component is late payments. Whether it was because you were struggling to make ends meet — or because you simply forgot — being late on a monthly payment for your credit card or a loan will usually cause a negative adjustment on your credit score.

  • How late you are with your payment also impacts your credit score. The later you are, the worse the impact — this is reflected on your credit report with late payments marked under categories like 30-days, 60-days or even longer.
  • Missed or late payments on what may seem like trivial amounts can be just as damaging.

The specifics of your existing debt burden account for 30% of your credit score, including how much you owe in total, what types of loans you have and any other quantitative indicators about your overall debt and credit profile. As an indicator of your creditworthiness, how much you owe and how it's broken up across different types of lending products acts as a signal about your capacity to manage your existing debt.

Example:

When it comes to how existing debt affects your credit score, less debt doesn't necessarily have a more positive impact. That's because the FICO calculation considers all components relative to each other, rather than taking each factor for face value.

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 that 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 (also known as your debt to limit ratio) 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’ll help lower the overall ratio.

The length of your credit history makes up about 15% of your credit score. This takes into consideration how long accounts under your name have been open, including the average amount across all your accounts, as well as the length of your oldest open account. 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 consumer is a better indicator for how they may act in the future than having only a few months' worth of information.

One of the smallest components of your credit score at 10% is the different types of debt or credit used. Your accounts are classified into categories like revolving credit (credit cards), mortgages, consumer finances or installment loans. 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 different financial products and can manage them appropriately. Consumers also may not have the same attitude towards paying off a credit card versus their mortgage, so a lender might want to be more cautious with someone with narrower exposure.

Recent searches or hard inquiries made into your credit profile accounts for 10% of your credit score. This tracks the number of times lenders have requested your data, and typically a consistent high number of requests will bring your score down.

  • Note that every hard inquiry made into your credit history, such as an application for a credit card, temporarily causes your credit score to go down. This won’t have a long lasting effect on your credit score, however.
  • Be aware that checking your own credit score doesn’t count as a hard pull on your credit history and will NOT result in a decrease in your credit score. In fact, it's recommended to check your credit score frequently to stay on top of your financial health. Issuers like Capital One offer tools that let you check your credit score for free without needing to be a cardmember.

What are the three main credit bureaus?

The three main credit bureaus in the United States are Experian, Equifax and TransUnion. Your credit data is reported to these providers who then determine your credit score based on the FICO scoring system. Each credit bureau will produce a different credit score, as they each use a slightly different scoring system and not all three bureaus typically have the exact same data about your credit history. This often occurs when an account in your credit history has been reported to one bureau but not another.

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How to improve your credit score

  1. Pay your balances on time and in full each month. This will help you avoid accruing debt and will establish a positive credit history.
  2. Lower your credit utilization rate. Whether this means spending less on your credit cards each month or asking your issuer to increase your credit limit, using less of your available credit overall can improve your credit score.
  3. Keep your number of credit cards and accounts at a manageable level. This will help you keep track of your balances and due dates without overwhelming you or getting you into debt.
  4. Check your credit score frequently. This doesn’t count as a hard pull on your credit history, and won’t impact your credit score. However, it's important to keep track of your credit score so you can take steps to improve or maintain it.

Frequently Asked Questions

How often should you check your credit score?

You should check your credit score regularly to help you maintain positive credit health. Checking your credit score is free through services provided by issuers like Capital One, and it does not result in a hard pull on your credit history, so it won’t impact your credit score.

What is the credit score range?

The credit score range is from 300 to 850, with higher scores being better. Good credit is considered to be anything from 670 and above.

How to get approved for a credit card?

In order to get approved for a credit card, you'll need to make sure your credit score is high enough. Most credit cards require consumers to have a minimum credit score in order to be accepted.

How is credit score calculated?

Your credit score is calculated based on a variety of factors, and each factor makes up a percentage of your overall score. These include payment history (35%), debt burden (30%), length of history (15%), types of credit (10%) and recent credit searches (10%).

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