How the Credit Score System Works – Everything You Need to Know
Credit can be confusing and intimidating, especially when it comes to credit scores. How is it calculated? What does it mean? What’s a good number? We will answer all your questions and explain how the credit score system works.
What is a Credit Score?
First of all, a credit score, also called my FICO (Fair, Isaac and Company, creators of the scoring system), is a 3-digit number between 300 and 800 used by lenders and creditors to assess the risk of lending you money or extending a new line of credit. A high score means that you are very likely to pay everything on time, while a low score indicates that you are a high risk debtor who may incur in default. Lenders also use this score to determine interest rates and the type of loan or credit card you qualify for.
How is it Calculated?
Your credit score is calculated based on the information on your credit report using five factors. Each factor has a certain “weight” assigned: some factors have a significant impact on your credit, while others are not as important.
- Payment history (35%)
As consequence of being the most important factor used to determine your FICO score, payment history can make a big difference in your credit rating. With this in mind, creating a positive payment history by paying all your bills on time is actually one of the easiest ways to improve your credit.
- Outstanding debt (30%)
This factor takes into account your total debt in relation to the amount of credit you have available, in other words, your credit utilization rate. Since it is another major factor in calculating your credit score that is completely under your control, eliminating credit card debt can be a great help in improving your credit score.
- Length of credit history (15%)
An established borrower is less risky than one that has just started, so the FICO credit scoring system takes into account how long a debtor has been. This also takes into account the time that each of your accounts has been open, so it is a good idea to leave old accounts open with zero balances, even if you are not using them.
- New credit (15%)
Having several new accounts opened in the recent past will offer a greater risk as a debtor because it will show many new obligations. With this in mind, creditors want to know how many new accounts you have recently opened. They also take into account the number of credit inquiries made in the recent past, as this indicates that a debtor is in search of several new accounts at once. Keep in mind that only “hard inquiries” count in the calculation of your score. “Soft inquiries” such as checking your credit report yourself do not count.
- Types of credit used (10%)
The types of credit you use also come into play when determining your credit risk. Some types of debt are more attractive to you than other types of debt with lenders and creditors, since they assess your risk. A mortgage and a car loan are good types of debt. Credit cards are considered better than store cards or retail accounts. This factor also takes into account the frequency with which you use different lines of credit that you have open.
What is Considered a Good Credit Score or a Bad Credit Score?
A good credit score must be in the middle to high 600. Experian, one of the main three credit bureaus, sets the limit on 670. Anything below this is considered a bad credit score. A few points can make or break your finances.
What is a Credit Report
All your creditors report your payments to the credit bureaus. The three main ones being Experian, TransUnion and Equifax, they keep a record of everything reported.
Your credit report is your entire financial history and contains all information related.
- Your address
- Credit limits
- Length of credit history
- Loan information
- Credit inquiries
- Late payment information
- Account names
- Whether you have been arrested, sued or have filed for bankruptcy
Every single time you pay your bills late is there, and becomes a negative item on your report, which ultimately affects your credit score. While your credit score is based on the information on your credit report, it isn’t listed there.
What Can You Do to Improve Your Credit?
- Pay down your credit card balance.
- Pay your bills and loans in time.
- Get inaccurate or negative items removed from your credit report.