How Credit Scores Work: Everything You Need to Know

Your credit score is a number that reflects the risk you pose to lenders. The higher your score, the lower the risk. Here’s how credit scores work and how you can improve yours.

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Introduction

Your credit score is a three-digit number that’s based on information in your credit reports. Lenders use credit scores to help them decide whether to give you a loan and how much interest to charge you. A higher score means you’re more likely to get approved for a loan with favorable terms, such as a lower interest rate.

Credit scores are calculated by using a mathematical formula that considers several factors in your credit reports, including:
-The types of credit accounts you have (such as credit cards, store charge cards, mortgage loans, etc.)
-How long each account has been open
-How much credit you’ve used on each account
-Whether you’ve paid your bills on time

You’re not likely to know your exact credit score because there are many different scoring models used by lenders. However, you can get an idea of where you stand by checking your credit reports for free at AnnualCreditReport.com.

How Credit Scores Are Calculated

Your credit score is a three-digit number that’s calculated by using information in your credit report . Lenders use credit scores to help them decide whether to give you a loan and how much interest to charge you. A high credit score indicates to lenders that you’re a low-risk borrower, which could lead to you getting a lower interest rate on a loan. A low credit score could lead to a higher interest rate and could mean you won’t be approved for a loan at all.

Payment history

Your payment history is one of the most important factors in your credit score—making up 35% of your FICO® Score☉ —because it shows creditors how you’ve managed credit in the past. A positive credit history (meaning you’ve made all your payments on time) will help boost your score, while even one missed payment can have a negative impact.

Your payment history includes information about all your past and present debts, including:
-Revolving debt, such as credit cards
-Installment debt, such as car loans or mortgages
-Public records, such as bankruptcies or foreclosures

When evaluating your payment history, creditors are looking at two things: whether you’ve paid on time and how often you’ve missed payments. Payment history is reported to the credit bureaus by your creditors, so if you have a history of late or missed payments, it will show up on your credit report—and could hurt your score.

Credit utilization

Your credit utilization, which is also called your balance-to-limit ratio, is the amount of money you owe on your credit cards divided by your credit limit. In other words, it’s how much of your available credit you are using at any given time.

For example, let’s say you have two credit cards. One has a credit limit of $1,000 and a balance of $500. The other has a credit limit of $3,000 and a balance of $1,000. Your total credit utilization would be 1,500/4,000 or 37.5%.

Your credit utilization makes up 30% of your FICO® Score☉ , so it’s important to keep it under control. You can lower your credit utilization by paying down your balances or asking for higher limits on your existing cards. Another option is to open a new account and transfer some of your balances to the new card to spread out your debt more evenly.

Length of credit history

One of the biggest factors in your credit score is your length of credit history, which is how long you’ve been using credit. This makes sense—a longer history means you’ve had more time to demonstrate responsible borrowing and repaying habits.

The length of your credit history is important because it’s one way lenders can assess your “creditworthiness.” That’s the likelihood that you’ll repay any debt you take on. If you have a long and positive credit history, lenders may see you as someone who’s more likely to repay a loan or other debt.

Length of credit history accounts for 15% of a FICO® Score☉ 8, so it’s an important factor in determining your score. It’s also one of the areas where older consumers tend to have an advantage over younger consumers. It can take time to build up a long credit history, so if you’re just starting out, don’t be discouraged—there are other things you can do to improve your score.

Types of credit

You have probably heard the term “credit score” before, but you may not know exactly what it is or how it is calculated. A credit score is a number that lenders use to assess your creditworthiness — in other words, how likely you are to repay a loan. The higher your credit score, the more favorable terms (lower interest rates, for example) you will be offered by lenders. Here’s a look at how credit scores are calculated, what goes into them and what you can do to improve yours.

There are two major types of credit: revolving and installment. Revolving credit refers to lines of credit that can be used repeatedly, such as credit cards. Installment credit refers to loans that must be repaid in fixed monthly payments, such as auto loans or mortgages. Lenders will look at both types of credit when considering a loan application.

Your payment history makes up the largest percentage of your credit score — 35% to be exact. Payment history includes on-time payments as well as any late or missed payments. A history of timely payments will boost your score, while late or missed payments will damage your score.

The second most important factor in your credit score is the amount of debt you have relative to your available credit — also known as your “credit utilization ratio” or “debt-to-credit ratio” This measures how much of your available credit you are using at any given time and makes up 30% of your credit score. For example, if you have a $10,000 credit limit and a balance of $5,000, your debt-to-credit ratio is 50%. A lower debt-to-credit ratio indicates that you are using less of your available credit and therefore appear less risky to lenders.

Lenders also consider the length of your credit history when calculating your Credit Score—15% to be exact . A longer history shows that you have a track record of managing debt responsibly and is therefore more favorable than a shorter history. Even if you don’t have a long history yet, there are things you can do to improve your score in this category.

New credit

Opening a new credit card or loan account will result in a hard inquiry on your credit report, which can temporarily lower your score by a few points. But if you manage your new account responsibly (by making payments on time, keeping your balance low, etc.), then your score should rebound relatively quickly. In the meantime, try to avoid opening any new accounts until your score has recovered.

The Impact of Credit Scores

Credit scores are important. They help lenders determine whether or not to give you a loan, and can also affect the interest rate you’re offered. A good credit score can save you a lot of money in the long run. A bad credit score can cost you in the form of higher interest rates and denied loans.

On your ability to borrow money

Your credit score is a number that represents your creditworthiness. Lenders use your credit score to determine whether you’re a good candidate for a loan and how much interest they should charge you. The higher your score, the better.

A good credit score is important because it can save you money in the form of lower interest rates on loans. A low credit score can also keep you from getting approved for a loan in the first place. In general, the higher your score, the better interest rate you’ll be offered by lenders.

Here’s a breakdown of how your credit score affects your ability to borrow money:

Excellent (720-850) – You will qualify for the best loan terms, including the lowest interest rates. You will likely have no problem getting approved for loans, including mortgages and car loans.

Good (690-719) – You will qualify for most loan products, but may not get the very best terms, such as the lowest interest rates. You should have no problem getting approved for most loans.

Fair (630-689) – You may still be able to get some loans with favorable terms, but you may have to pay higher interest rates. Your approval odds will be lower, but not necessarily impossible. For example, you may still be able to get a mortgage but may have to pay a higher interest rate than someone with an excellent credit score.

Poor (300-629) – Your chances of getting approved for a loan are very low, and if you are approved, the terms will likely be very unfavorable, such as high interest rates and short repayment periods.

On your insurance rates

Your credit score can have a big impact on your ability to get affordable insurance. In general, the higher your credit score, the lower your insurance rates will be. Insurance companies use credit scores to help them determine how likely you are to file a claim. If you have a high credit score, that means you’re less likely to file a claim, and the insurance company will offer you a lower rate. However, if you have a low credit score, that means you’re more likely to file a claim, and the insurance company will charge you a higher rate.

On your employment prospects

Your credit score doesn’t just impact your ability to borrow money. It can also have an effect on your employment prospects. Many employers now routinely check job applicants’ credit scores as part of the hiring process.

There are a few reasons why employers might be interested in your credit score. For one thing, employers may believe that your credit score is a good indicator of your level of responsibility. If you’re careful about managing your finances, the thinking goes, you’re likely to be a responsible employee.

In addition, employers may be concerned that employees with poor credit scores may be tempted to steal from the company in order to make ends meet. While this is not always the case, it is something that employers take into consideration when reviewing job applicants’ credit scores.

If you’re concerned that your credit score could hurt your chances of getting a job, there are a few things you can do. First, try to get a copy of your credit report and score before you start applying for jobs. This way, you’ll know what potential employers will see when they run a credit check.

If you find that your credit score is lower than you would like, there are steps you can take to improve it. For example, you can work on paying down any outstanding debt that you have. You can also make sure to keep up with all of your future payments so that you don’t end up with any more missed or late payments on your record.

In general, the higher your credit score, the better off you’ll be when it comes to employment prospects. So if you’re concerned about your credit score impacting your ability to get a job, take steps now to improve your score and make yourself a more attractive job candidate.

Ways to Improve Your Credit Score

There are a lot of factors that go into your credit score, and it can be hard to keep track of everything. However, there are some things you can do to improve your credit score. In this article, we’ll go over some of the ways you can improve your credit score.

Pay your bills on time

One of the biggest factors in your credit score is whether you pay your bills on time.

Your payment history comprises 35 percent of your credit score, so late or missed payments can heavily impact your score. If you have a history of late payments, you may want to consider signing up for automatic bill pay or setting up reminders to help you stay on track.

Paying your bills on time is one of the most important things you can do to improve your credit score.

Keep your credit utilization low

One factor that affects your credit score is credit utilization, which is the percentage of your available credit you’re using at any given time. For example, if you have a $1,000 credit limit and a balance of $500, your credit utilization is 50%.

Ideally, you want to keep your credit utilization below 30% to maintain a good credit score. If it’s getting close to 30%, try to pay down your balance as quickly as possible. You can also ask your creditors for a higher credit limit, which will lower your credit utilization ratio.

Don’t open new credit accounts unnecessarily

Opening a new credit account—be it a credit card, a mortgage, or a car loan—can result in a temporary dip in your credit scores. That’s because your credit utilization ratio—a key factor in credit scores—usually goes up when you have more debt.

Fortunately, the impact of new credit on your credit scores tends to be small and short-lived. And if you manage your new account responsibly, your scores should rebound soon enough.

Still, there’s no need to open a new account if you don’t need it. So if you’re considering opening a new account to help improve your credit scores, make sure it’s something you really need.

Dispute errors on your credit report

If you find errors on your credit report, you can dispute them with the credit bureau in charge of that report. You should also notify the creditor or company that provided the information to the credit bureau.

According to the Fair Credit Reporting Act (FCRA), you have the right to request a free copy of your credit report from each of the three major credit bureaus every 12 months. You can also get a free credit report if you’ve been turned down for a loan or credit card within the past 60 days, if you’re on welfare, or if you’re unemployed and plan to look for a job within 60 days.

If you find errors on your credit report, you can dispute them with the credit bureau in charge of that report. You should also notify the creditor or company that provided the information to the credit bureau.

According to the Fair Credit Reporting Act (FCRA), you have the right to request a free copy of your credit report from each of

Conclusion

Now that you know how credit scores work, you can take steps to improve your credit health and get on the path to financial security. Remember, your credit score is just one factor that lenders consider when assessing your creditworthiness — but it’s an important one. So make sure to keep an eye on your score and take steps to improve it if necessary. By doing so, you’ll be well on your way to a brighter financial future.