A credit score is a number used to provide an overview of your financial health and responsibility. It pulls information from your credit reports and uses an algorithm to come up with a number, somewhere between 300 and 850.
The purpose of a credit score and your credit reports is to give lenders and others a quick, easy way to assess the level of risk they will be taking if they enter into a financial relationship with you. It’s used by lenders, landlords, insurance companies and others to determine your level of risk and responsibility.
Credit scores are calculated using an algorithm. Anytime you borrow money from a lender, information about that account was likely shared with at least one of the three major credit bureaus (Equifax, TransUnion and Experian). If you’re seeking credit from a bank or credit union, they will use the information from these credit bureaus to make a lending decision.
Manually combing through all the details of your credit and payment history would be a cumbersome task for any lender. That’s why lenders depend on credit scoring companies like FICO® to generate your credit score.
There are various different credit scoring formulas currently in use, but most of them operate on a scale of 300–850. Each credit score has its own variations on the same basic concept. The most commonly used scoring method, maintained by the Fair Isaac Corporation, is the FICO Score.
If a lender has ever pulled your credit report and gotten back to you with your current credit score, there is a very good chance it was a FICO® Score they gave you, as the FICO® Score is used in about 90 percent of all lending decisions made in the U.S. Although there are no official distinctions, the following credit score ranges are generally accepted ranges used by many lenders:
Of course, regardless of the label anyone chooses to put on a score, the bottom line is the higher your credit score, the more likely you are to be extended credit, and the less you will have to pay for it.
Old, active credit cards keep your credit age high and contribute to your overall available credit, thus positively impacting your utilization ratio.
Some companies may close old cards if they don’t see any activity. One trick to avoid this is to automate payments with that card. For example, you can set up autopay for a bill to the card and then set up autopay from your bank account to the card.
There are times when keeping an old card open might not be the best option for you since you may need to pay annual fees and any other associated expenses. If you need to close a card, you should calculate your utilization ratio with the remaining credit you have available to see where your ratio will fall.
Payment History: 35%
Lenders want to see that you consistently pay your bills on time, and that you pay at least the minimum required amount each time they’re due. Even one late payment or missed payment can have a serious impact on your credit score, so prioritize making payments on time and for the full amount.
Credit Utilization: 30%
This is how much of the total amount of credit available to you is being used. The rule of thumb is to keep your credit utilization at or below 30% of your overall credit limits. For instance, if you have a total credit limit of $10,000 available, try to keep your balance below $3,000.
Credit Age: 15%
Everything else being equal, a longer credit history scores better than a shorter one. To raise your score, even if an account has a $0 balance, do not close the account. As it stays on your record, it adds to your total available credit and the total length of your credit history.
Number of Inquiries: 10%
A hard inquiry occurs when a lender pulls your credit report in response to your request for credit, such as when you apply for a credit card or a car loan. A large number of inquiries in a fairly short time will drop your score dramatically, so make sure to do your due diligence ahead of time and only fill out an application when it is truly needed and/or you are certain you can handle the responsibility.
Different Types of Credit: 10%
This factor displays a well-rounded credit history. Primarily, the mix will consist of revolving debt (credit cards) and installment debt (car loans, student loans).
There are several ways to hurt your credit score. As you may have guessed from the previous list, not paying your bills on time is one of the most common ways credit scores suffer. Some other common mistakes people make that result in a bad credit score include:
Making late payments (Payment History)
Maxing out credit cards (Credit Utilization)
Applying for too many credit cards (Number of Inquiries)
Closing $0 balance lines of credit (Credit Age, Credit Utilization)
Refusing to use credit at all (Credit Age, Different Type of Credit)
There are more things that can negatively impact your credit. It’s important to remember that inaction can have just as much impact as positive or negative action, so it’s important to be proactive if you want to improve your credit score.
Bad credit certainly won't do anything in your favor to impress potential lenders, landlords or employers. The bottom line is they are likely to view your unstable financial past as a good indication of your future financial behavior. Because of the perceived business risk, lenders may not approve you.
If they do, they’ll likely charge you higher interest rates. Employers may decide to pass you over in favor of someone with better credit. Additionally, insurance companies may charge higher premiums to compensate for your perceived high-risk.
Your credit scores are only based on facts and are not meant to be biased against you. Some of the things that don’t impact your credit score are:
Your national origin
Occupation and employment history
Additionally, if you have received public assistance in the past, this is not factored into your score. U.S. law protects individuals from discrimination by prohibiting these items from being part of your credit score.
It’s also important to note that if you’re applying for something big like a car loan or a mortgage, the lender may ask you for your salary and employment status to make sure you can pay the loan back, but this has no bearing on your credit score.
There are many ways to improve your credit score. Keeping old credit cards open is one way to improve the length of your credit history. Another is to spread out credit card debt across multiple cards. Always pay off your highest interest debt first and make payments before credit card companies make updates to the credit bureaus. You can learn more about how to improve your credit score and build credit.
Not every individual with a bad credit score is a high risk. Cases of identity theft, inaccurate information and other examples of unfair credit reporting may depict you in an unjustifiably wrong light.
It’s up to you to determine whether your credit score accurately reflects your financial past. That’s why you should take advantage of your rights under the Fair Credit Reporting Act, including your right to a free credit report from each of the major credit bureaus every year, and the right to dispute any unfair, inaccurate or unsubstantiated items you find on that report.
The good news is that Federal Law regulates the credit reporting agencies. You have a right to a fair and accurate credit report and can dispute information that is inaccurate, unfair or unverifiable. If you’re not sure how to dispute information on your credit reports, or feel overwhelmed, you can seek help from qualified professionals who can guide you through the process and act as advocates for you.