How Do Credit Scores Work?

Knowing your credit score can be an important step in your financial life. A credit score helps determine what type of risk you are to lenders. It can also affect the interest rate you’re offered on credit cards, auto, and home loans.

The higher the credit score you have, the more likely you are to qualify for low interest rates. A good credit score can be the difference between being able to afford something or a payment completely out of reach due to a higher rate.

Before making a major purchase with a credit card or even applying for credit, it can be wise to know your credit score and work on improving it if necessary. Here are some things to know about how credit scores work:

How to check your credit score

Federal law requires each of the nationwide credit reporting companies — Equifax, Experian, and TransUnion — to provide you with a free copy of your credit report, at your request, once every 12 months.

Free reports are available at AnnualCreditReport.com. Reports from all three companies can be requested at the same time or you can order them one at a time. All are free once a year. If you order one bureau report every four months, you’ll be able to regularly review your credit report throughout the year.

What is a credit score?

The credit score in a credit report is a number that represents your credit risk at a certain point in time. It’s meant to measure your future credit risk.

Credit scores from the Fair Isaac Corporation, or FICO, are the most widely used. The three main credit bureaus collect information about borrowers and come up with FICO scores ranging from 300 to 850.

Scores may differ with each credit bureau and lenders may have their own criteria to add to the score to determine a borrower’s credit risk. Each credit bureau’s score is based on information it has and not on data from other bureaus.

What the numbers mean

A high score means low risk and better rates from lenders. Credit scores from Equifax, TransUnion and a FICO competitor — VantageScore 3.0 — have the same range of 300 to 850. Experian has a range of 330 to 830.

Lenders can view the same score differently. A FICO score of 680 may equate to lower auto loan terms from one lender, while another may require 740 to get the same loan rates. While there isn’t a score that all lenders use, there are some generalities:

• 781 and above is excellent and should lead to the lowest interest rates on loans or revolving lines of credit.
• 661-780 is very good and should allow you access to most lines of credit.
• 501-600 is fair, and you may have to pay slightly higher interest rates than those with higher scores.
• 500 or lower points to significant credit problems, meaning you may have a difficult time getting credit.

How credit scores are determined

FICO scores are calculated with different pieces of credit data about an applicant, using both positive and negative information.

A minimum amount of recent information about an applicant is required in order to have a FICO score. A borrower needs to have at least one account open that is reported to the bureaus for at least six months.

Here’s the information that FICO says it uses to determine credit scores, along with the percentage of the each factor that goes into a score:

• Payment history: 35%. This includes paying bills on time without delayed or missed payments. A long history of making payments is also important.
• Amounts owed: 30%. Having credit accounts and owing money on them doesn’t mean you’re a high-risk borrower with a low FICO score. This part of the score includes your credit utilization ratio, which is the ratio of outstanding debt to available credit. Having no more than 10% of debt to credit leads to the highest rating.
• Length of credit history: 15%. The longer credit history you have, the better your credit score will be. The age of your oldest account, newest account and an average age of all your accounts is considered. It also looks at how long it has been since you used certain accounts.
• Credit mix in use: 10%. Your score will be based on your mix of credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans. The more diverse, the better.
• New credit: 10%. Opening several credit cards in a short period of time represents a greater risk, especially for people without a long credit history. Each credit application generates a credit inquiry. One or two inquiries per year is fine.

What’s not in your credit score

There are certain factors that aren’t allowed by federal law to be used in determining credit scores. As far as FICO scores go, scores cannot include race, color, religion, national origin, sex, marital status and age. Salary, occupation, title, employer, date employed or employment history aren’t considered in FICO scores either. Lenders however, may use this information in order to qualify a borrower.

FICO also cannot use your place of residence, an interest rate charged on a particular card, family support obligations and certain types of requests for your credit report. As a consumer, any requests you’ve made to check your credit is considered a soft inquiry and does not affect your score, nor does it show up on your report.