The Basics of Credit Scores

A credit score is a number that is calculated based on your credit history to give lenders a simpler "lend/reject" answer for people who are applying for credit or loans. This number helps the lender identify the level of risk they may be taking if they lend to someone. While the same end result can come through reviewing the actual credit report (which lenders usually do), the credit score is quicker and less subjective. The system awards points based on information in the credit report, and the resulting score is compared to that of other consumers with similar profiles. With this information, lenders can predict how likely someone is to repay a loan and make payments on time. It's the credit score that makes it possible to get instant credit at places like electronics stores and department stores.

Although there are several scoring methods, the score most commonly used by lenders is known as a FICO because of its origins with Fair Isaac and Company. Fair Isaac is an independent company that came up with the scoring method and software used by banks and lenders, insurers and other businesses. Each of the three major credit bureaus (Experian, Equifax and TransUnion) worked with Fair Isaac in the early 1980's to come up with the scoring method.

The three national credit bureaus each have their own version of the FICO score with their own names. Equifax has the Beacon system, TransUnion has the Empirica system, and Experian has the Experian/Fair Isaac system. Each is based on the original Fair Isaac FICO scoring method and produces equivalent numerical results for any given credit report. Some lenders also have their own scoring methods. Other scoring methods may include information such as your income or how long you've been at the same job.

Your credit score is calculated in a weighted formula. It uses the information in your credit report. The number itself can range from 300 to 900. The formula for exactly how the score is calculated is proprietary information and owned by Fair Isaac. Here, however, is 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 timely) you pay your bills. The score is affected by how many bills have been paid late, how many were sent out for collection, any bankruptcies, etc. 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% 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 the number of inquiries on your report.

If you've applied for a lot of loans, you will have a lot of inquiries on your credit report. Excessive inquiries possibly indicate that you are in financial trouble or may take on a lot of debt. Recent credit inquiries may negatively affect your credit scores, but if the inquiries stop, the impact is usually short-lived. Every time when you refinance your home loan or have your credit history checked (for example, your landlord may check your credit before leasing an apartment), you will have a credit inquiry. Normal number of credit inquiries are not considered excessive and you don't have to be overly concerned. Your credit scores may dip a little bit, for example, 10 points, and quickly bounce back a couple weeks later. FICO scores only count inquiries from the past year.

10 percent of the score is based on the types of credit you currently have.

The number of loans and available credit from credit cards you have makes a difference. There is no magic number or combination of types of accounts that you shouldn't have. These actually come more into play if there isn't as much other information on your credit report on which to base the score.

This information is compared to the credit performance of other consumers with similar histories and profiles.

Your credit score doesn't just affect whether or not you get a loan; it also affects how much that loan is going to cost you. As your credit score increases, your credit risk decreases. This means your interest rate decreases.

There are other factors that influence the interest rate you get for a loan besides your credit score, such as seasonal promotions, the costs the lender has to make the loan, etc.

In addition to banks and lenders, there are landlords, merchants, employers and insurance companies jumping on the credit score bandwagon.

Credit scores aren't static numbers. Because they are 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. The key is to improve your credit score is to use your credit cards carefully, make your payments on time, and keep your balances low. Remember not to max-out credit cards.