How Do Credit Scores Work?

Your three-digit credit scores — and, yes, that is “scores” plural — tell lenders a lot about you. They can tell lenders if you always pay your bills on time or if you have a habit of paying your car loan or credit card bills late. They tell lenders whether you’ve run up thousands of dollars of credit card debt or if you’ve had bankruptcies in your recent past.

Lenders rely on these scores when you apply for loans or credit cards. If your scores are too low, you might not qualify for that car loan or mortgage loan. And if you do qualify, the lender or banks with which you are working will give your loan a high interest rate, making it more expensive for you to borrow that money.

This is why it’s important for you to not only know what your credit scores are — at least some of them — but how they work and how your financial habits can cause them to rise or fall.

The good news? Credit scores aren’t nearly as complicated as you might think. You can keep them strong by paying your bills on time and keeping your credit card balances low.

Here, then, is a look at the basics of credit scores, how they work, why they’re so important and what you can do to keep them from plummeting.

The history of the FICO® Score

There are several credit scores that lenders can use to determine how likely you are to pay your bills on time. But none of these scores is as important, or widely used, as the FICO® Score, the credit score developed by a tech company called Fair, Isaac, and Company – known today as FICO.

The history of credit scores is a long and complicated one. FICO, on its blog, says that credit-reporting companies first started evaluating the financial habits of consumers, and not just businesses, in the 1900s. Retail Credit Company, based in Atlanta, was a good example: The company collected data on millions of Americans, according to FICO.

The problem? Retail Credit Company didn’t just collect credit information. The company also compiled data on the social, political and sexual lives of consumers.

In 1970, though, the Fair Credit Reporting Act (FCRA) changed this. The federal law required credit-reporting agencies to make their data available to the public. Just as importantly, the law forced these agencies to eliminate data on sexuality, race and disability from their credit reports.

The law required another change that benefits consumers today: Credit agencies must eliminate negative data, including late payments, bankruptcies, and foreclosures, after a specified number of years. That requirement still holds today, which is why your missed or late payments, and other financial missteps, will eventually fall off your credit reports.

Another interesting fact? Retail Credit Company, in 1975, changed its name to Equifax, one of the three national credit bureaus. Equifax still operates today, along with its fellow credit bureaus of Experian and TransUnion. These bureaus compile the credit reports that determine your FICO® Score.

The actual FICO® Score that lenders rely on today debuted in 1989. The score came about when the three credit bureaus worked with Fair, Isaac, and Company to come up with a score that would better predict consumers’ likelihood to pay their bills on time. That score, of course, became the FICO® Score, named after Fair, Isaac, and Company, which has since changed its name to FICO.

You don’t have just one FICO® Score, but dozens. The most important ones, though, are the three maintained by the credit bureaus, one each by Experian, Equifax, and TransUnion. Each of these scores might be slightly different, but they should all be similar. FICO® Scores range from a low of 300 to a high of 850. What’s considered a good score can change, but most lenders consider scores of 740 or higher to be strong ones.

FICO® says that its score today is used by 90 percent of the country’s top lenders.

What impacts your credit score?

What causes your credit score to rise or fall? The most important factor affecting your credit score is payment history. In general, if you pay your bills on time, your FICO® Score will be higher.

There is a catch, though: Not all bill payments are reported to the credit bureaus. Those that are reported include your mortgage, student loan, car loan, and credit card payments. If you pay these bills on time every month, the odds are high that you’ll have a strong credit score. If you pay any of them late by 30 days or more, your credit score will fall, possibly by 100 points or more.

Your credit card debt is important, too. If you have too much credit card debt, your credit score will suffer. The more you reduce your credit card debt, the more positive impact you’ll have on your credit score.

Those are the two most important factors influencing your score. But the age of your credit affects your credit score, too. The older the credit, the more positive an impact it has on your credit score. Younger lines of credit, such as a brand-new credit card account, will have a negative impact on your credit.

Your mix of credit will impact your score, too. Your score will benefit if you have a variety of types of credit. If you have a car loan, student loan, mortgage loan, and credit cards, this will be a positive. Only having one form of debt — say, credit card debt — can hurt your score.

Finally, your score will take a hit, sometimes small, whenever a lender or bank checks your credit after you request a new loan or credit card. These checks are known as hard inquiries, and can cause your credit score to dip slightly, usually by five points or less

What doesn’t impact your credit score

There are several other financial factors that have no impact at all on your credit scores. Your job or how much money you earn each year does not cause your credit score to rise or fall. The same holds true for your savings: A large savings account won’t help your credit score, while an empty one won’t hurt it.

Certain late payments won’t hurt your credit score at all. Late payments to doctors, your cell phone provider, your utility company, or your dentist aren’t reported to the credit bureaus, so they won’t cause your score to fall. Rent payments typically fall in this same category. However, some landlords now do report your monthly rent payments to the bureaus. Usually, though, they won’t.

Types of credit scores

You have a lot of different credit scores. Here are five of them.

FICO® Score

Your FICO® credit score is the most important score of them all. This score ranges from 300 to 850. It’s the score that lenders usually rely on when determining if you qualify for loans or credit.

Equifax Credit Score™

Equifax has developed its own credit score. It is similar to the FICO® Score, but has a scale ranging from 280 to 850. Again, this not a credit score that lenders use. Instead, it’s what is known as an education score, one that consumers can check to determine if their credit is strong.

TransUnion CreditVision® New Account Score 2.0

The credit bureau TransUnion also offers its own score, the New Account Score 2.0, which has a range of 400 to 925. This score helps financial institutions managing their existing accounts determine their levels of risk. Again, it is not a score that lenders will use to determine who qualifies for a loan or a new credit.

The VantageScore®

All three credit bureaus — TransUnion, Equifax and Experian — developed the VantageScore® in 2006 to serve as an alternative to FICO® scores (https://your.vantagescore.com/why-we-exist). This score, for the most current version, ranges from 300 to 850. Scores for the earlier VantageScore models ranged from 501 to 990.

What’s important to understand is that these scores are just a small sample of the number of credit scores out there. Still, when applying for a mortgage, your FICO® credit score remains the most important.

The components of your credit

Your FICO® Score is the most important of your many credit scores. It makes sense, then, to understand how this score is determined. Here are the five factors that make up your FICO® credit score (https://blog.myfico.com/5-factors-determine-fico-score/):

Payment history

FICO® says that your payment history determines 35 percent of your FICO® Score. Missed or late payments on your credit cards, mortgage loan, student loan, auto loan, and other installment loans will cause your score to fall. Missed or late payments remain on your credit reports for seven years before falling off.

The amount you owe

The amount of your credit that you are using accounts for 30 percent of your credit score, according to FICO. That’s why it’s important to not carry high balances on your credit cards. FICO® says that credit score formulas consider borrowers who frequently hit or exceed their credit limits as higher risks.

Length of credit history

The age of your credit accounts makes up 15 percent of your credit score. Basically, consumers with a longer history of using credit will get a boost to their credit score, FICO® says.

Credit mix

The makeup of your credit accounts for 10 percent of your credit score, FICO® says. Credit score formulas favor consumers who have a combination of credit cards, installment loans, mortgages and other forms of debt that they are repaying. FICO, though, also says that your credit mix has a relatively low impact on your credit score when compared with how much credit you are using and your payment history.

New credit

Opening several new credit accounts in a short period could hurt your score. That’s because your new credit makes up 10 percent of your credit score, FICO® says. Opening up several new lines of credit can be more damaging to consumers who already have a shorter credit history, according to FICO.

How to keep an eye on your credit scores

It’s smart to know your credit score. But how do you check up on your credit score?

You can order one free copy of each of your three credit reports – one each maintained by Experian, Equifax and TransUnion – once a year from AnnualCreditReport.com. Credit reports, however, are not the same as your credit score. Your reports list your open account balances, how much you owe on your loans and whether you have any recent late payments, bankruptcies or foreclosures on your record. This information is used to determine your credit score. While these reports won’t list your credit score, they will provide you with important information about your credit history and are worth ordering.

You can order your FICO® Score directly from Equifax, Experian and TransUnion. This won’t be free, though. The credit bureaus charge. Be careful if you are ordering your score; you don’t want to accidentally sign up for a monthly credit-monitoring service if you don’t want it.

Your bank and credit cards might also send you a free credit score with their statements. A growing number of financial institutions are doing this. This free score might not be your actual FICO® Score. But the score should at least be close to your FICO® Score. If the free scores your bank or credit companies are sending you are high, your FICO® Score is probably strong, too.