How Credit Scores Work

We depend on credit for so many important things in life -- whether it's for buying a car, house or computer or getting a student loan. A three-digit number -- your credit score -- can determine whether you can do these things and even how much it will cost you.

How can a simple number determine whether you can buy a house or car? If you've read How Credit Reports Work, you know that your credit report contains a history of how you've paid your bills, how much open credit you have, and anything else that would affect your creditworthiness. Your credit score boils down all of that information to a three-digit number. Using the credit score, lenders can predict with some accuracy how likely the borrower is to repay a loan and make payments on time. It's how electronics and department stores can offer instant credit.

This incredibly important number, which affects how much you pay for credit, insurance and other life necessities, used to be hidden from consumers. Until recently, only lenders and other businesses that used the score could access it. Fair Isaac and Company, which developed the score, felt that the score would only confuse consumers since there was nothing to tell them what it meant or what lenders were looking for.

In 2001, however, all of this changed due to pressure from the U.S. Congress and industry and consumer groups. Now you can view your credit score -- for a fee -- from credit reporting agencies and credit monitoring services.

But to help us understand that number and ultimately know how to improve it, we'll need to find out how it's calculated.

Contents

Credit Score Breakdown
What Your Score Affects
Improving Your Score

Credit Score Breakdown

Although there are several scoring methods, most lenders use the FICO method from Fair Isaac Corporation. Each of the three major credit bureaus (Experian, Equifax and TransUnion) worked with Fair Isaac in the early 1980s to come up with the scoring method.

A credit score is determined much like a grade in school. Consider how a teacher calculates grades by taking scores from tests, homework, attendance and anything else they want to use, weighing each one according to importance to come up with a final, single-number score. It's the same for a credit score. But instead of using the scores from pop quizzes and papers, it uses the information in your credit report.

The number ranges from 300 to 850. Although the exact formula for calculating the score is proprietary information and owned by Fair Isaac, here's an approximate breakdown of how it is determined:

35 percent of the score is based on your payment history. This makes sense since one of the primary reasons a lender wants to see the score is to find out if (and how promptly) you pay your bills. The score is affected by how many bills have been paid late, how many were sent out for collection and any bankruptcies. When these things happened also comes into play. The more recent, the worse it will be for your overall score.
30 percent of the score is based on outstanding debt. How much do you owe on car or home loans? How many credit cards do you have that are at their credit limits? The more cards you have at their limits, the lower your score will be. The rule of thumb is to keep your card balances at 25 percent or less of their limits.
15 percent of the score is based on the length of time you've had credit. The longer you've had established credit, the better it is for your overall credit score. Why? Because more information about your past payment history gives a more accurate prediction of your future actions.
10 percent of the score is based on new credit. Opening new credit accounts will negatively affect your score for a short time. This category also penalizes hard inquiries on your credit in the past year. Hard inquiries are those you've given lenders permission for, as opposed to soft inquiries, which include looking at your own score and have no effect on the score. However, the score interprets several hard inquiries within a short amount of time as one to account for the way people shop around for the best deals on a loan.
10 percent of the score is based on the types of credit you currently have. It will help your score to show that you have had experience with several different kinds of credit accounts, such as revolving credit accounts and installment loans.

This information is compared to the credit performance of other consumers with similar histories and profiles. The three major credit bureaus each have their own version of the credit score, all of which are based on the original Fair Isaac scoring method. Equifax has the BEACON system, TransUnion has the classic FICO Risk Score system, and Experian has the Experian/Fair Isaac RISK system. Some lenders also have their own scoring methods, which may include information such as your income or how long you've been at the same job.

When it's all said and done, just how important is this magic number? And what does it mean for your interest rates?

What Your Score Affects

If you aren't careful about your credit, you could end up paying dearly for a low credit score. Not only can a low score stand in the way of getting a loan for your dream home or dream car, but even if you do get the loan, a less-than-stellar score will make it expensive.

As your credit score decreases, you become more of a credit risk in the eyes of lenders. This means they'll attach a higher interest rate to your loan, and your monthly payments will jump. On the other hand, a high score will lower that interest rate. Consider this pie chart, which illustrates the relationship between credit scores and interest rates:

This next chart shows an example of how interest rates for a car loan can vary based on your credit score:

chart on how interest rates for a car loan can vary based on your credit score

Although the score has a big impact, keep in mind that there are other factors that influence the interest rate you get for a loan besides your credit score. These might include things like the type of property you are using the loan to buy, how much of your own money or equity is going into it, the costs the lender pays to make the loan and so on.

In addition to banks and lenders, there are landlords, merchants, employers and insurance companies jumping on the credit score bandwagon. Of all of these, the fact that insurance rates are being determined by credit scores is causing consumers the most alarm. To most, it seems that your credit history and your driving record have little in common. Insurers, on the other hand, have found that credit scores help them predict how likely someone is to file claims. The rule of thumb is the lower the score, the higher the likelihood of filing claims. They don't use the same score that banks and lenders use, however. They use a slightly different formula for their calculations and actually call it an insurance score.

Insurers' use of credit histories to determine rates is under scrutiny nationwide. Many states are passing laws restricting this practice. In a few states, insurance companies can't make decisions based solely on credit. In some others, if an insurance company makes a decision that negatively affects your policy based on your credit, it must disclose to you the reasons behind the decision [source: CreditInfoCenter].

Another practice that particularly upsets consumers has to do with credit card companies' policy of universal default. Although we've already learned how a credit score can determine your interest rate, in the case of credit cards, your interest rate can change at the drop of a hat -- or rather, at a drop in your score. Even if you always pay your credit card bill on time, if you default on a completely separate loan, your the interest on your credit card debt could rise dramatically.

All this adds up to say that credit scores are enormously important. So putting a little thought into improving your score could prove a good investment.

Improving Your Score

Credit scores aren't fixed in stone. Because they're calculated based on your current credit report, they change every time your credit report changes. While this change may be very slight, it can also be much more dramatic. Here are some things some financial advisers say to do to try to improve your score:

Review your credit report and correct any errors you find. A shocking percentage of credit reports contain errors -- one study concluded that as much as a quarter of reports list wrong information that hurt an individual's score [source: CNNMoney]. Getting rid of these negative mistakes can improve a score dramatically.
Keep old credit accounts, even if you're not using them. Creditors look at the debt-to-credit limit ratio and the average age of your accounts.
Reduce your balances on credit cards to 75 percent or less of your available credit (25 percent is preferable).
Pay your bills on time. Assuming that there are no big errors on your report, punctual payments are the most effective way to improve your score. If you look back to the page on credit score breakdown, you'll see that payment history is the most weighty of all elements of your score. This has to do with whether you pay debts back on time and in full. This may take time to raise your score dramatically, but you'll see slow and steady improvement.
Don't let anyone make an inquiry on your credit report unless you absolutely have to. In general, the more inquiries, the lower your score. However, if you are shopping for a loan, make sure multiple inquiries occur within a few weeks, so that they can count as one inquiry on your score.
If you are planning on applying for a big loan, such as a mortgage, don't open new credit card accounts just to increase your available credit in the hopes of raising your score. Opening new accounts will at first have a negative impact. In the long term, however, having more credit available can boost your score.

If you go to the bank for a loan and are turned down because your score is too low, your would-be lender will get a list of reasons for that low score. You can use that list to try to turn your score around. Since lenders can also use their own scoring methods, nothing is guaranteed, but you certainly can't hurt your score by taking any of these steps.

If you'd like to learn more about credit, loans and financial planning, follow the links on the next page.

Frequently Answered Questions

Is a 700 credit score high?

A 700 FICOÂ® Score is Good, but by raising your score into the Very Good range, you could qualify for lower interest rates and better borrowing terms. A great way to get started is to get your free credit report from ExperianÂ® and check your credit score to find out the specific factors that impact your score the most. Is it better to pay off your credit card or keep a balance? Credit cards are great tools for building your credit history, and you donâ€™t need to carry an outstanding balance to build credit. Your best strategy is to use your credit cards and pay off the bill in full each month, so you keep your overall debt-to-credit limit ratio low. What is a decent credit score? For a score with a range between 300-850, a credit score of 700 or above is generally considered good. A score of 800 or above on the same range is considered to be excellent. Most credit scores fall between 600 and 750.