How Credit Scores Work and What They Say About You
A credit score is a number that helps lenders decide whether or not to approve a loan and what types of loans to offer. The score is generated by an algorithm using information from your credit reports, which summarize your borrowing history.
Credit Score Basics
Credit scores are designed to make decisions easier for lenders. Banks and credit unions want to know whether or not you’re likely to default on your loan, so they look at your borrowing history for clues. For example, they want to know if you have borrowed money before and successfully repaid loans or if you recently have stopped making payments on several loans.
When you get a loan, lenders report your activity to credit bureaus, and that information is compiled into credit reports. Reading through those reports is time-consuming, and it can be easy to miss important details.
With credit scores, a computer program reads that same information and spits out a score—a number lenders can use to evaluate how likely you are to repay. Instead of spending 20 minutes on each loan applicant, scores take much less effort to generate.
Credit scores also can be beneficial to borrowers. Lenders are less able to use subjective judgment when a score tells them most of what they need to know. Scores shouldn’t discriminate based on how you look or how you act.
Types of Scores
You have multiple credit scores. For every scoring model that’s been developed, you have at least one score. Most people refer to FICO credit scores, but you have a different FICO score for each of the three major credit bureaus: Equifax, Experian, and TransUnion. When talking about your credit, it’s important to understand specifically what type of score is being used.
Traditionally, the FICO score is the most popular score used for important loans like home and auto loans. No matter what score you use, most models are looking for a way to predict how likely you are to pay your bills on time.
The FICO credit score looks at how much debt you have, how you’ve repaid in the past, and more. Scores fall anywhere between 300 and 850 and are made up of the following components:
- Payment History: 35 percent. Have you missed payments or defaulted on loans?
- Current Debt: 30 percent. How much do you owe (and are you maxed out)?
- Length of Credit: 15 percent. Is credit new to you, or do you have a long history of borrowing and paying it back?
- New Credit: 10 percent. Have you applied for numerous loans in the recent past?
- Types of Credit: 10 percent. Do you have a healthy mix of different types of debt (auto, home, credit cards, and others)?
Some people don’t have a history of borrowing because they're young, they've never taken out a loan before or had a credit card, or for other reasons. For these types of loan applicants, “alternative” credit scores look at other sources of information for payment histories, such as utility bills, rent, and more.
Keep Tabs on Your Credit
Free credit reports are available to all U.S. consumers under federal law. To get your report from the three major credit reporting agencies, visit AnnualCreditReport.com. Remember that your scores are based on the information in your credit reports. If your credit reports look good, your scores will be high.
Free credit scores are harder to come by, but it's become increasingly common for some credit cards or banks to provide free credit scores just for being a customer. Also, ask your lender for your score any time you apply for a loan.
Access to your credit reports is important because sometimes they contain errors. When this happens, you can miss out on opportunities that you otherwise deserve. It's essential that you get those errors corrected in case anybody is asking about your credit. For time-sensitive fixes (when you’re applying for a mortgage and buying a house), rapid rescoring can get your scores higher within a few days.
Credit scores alone do not determine whether or not your loan request will be approved. They are simply numbers generated from your credit report and a tool to be used by lenders. They set standards for which credit scores are acceptable and make the final decision.
To improve your credit scores, you have to show that you're a seasoned, responsible borrower who is likely to repay on time. If you build your credit files with positive information, your credit scores will follow. It takes time, but it is possible.