How Do Credit Scores Work?

About Credit Scores

Credit scores have been likened to report cards for adults. It's true in as much as they reflect an individual's financial decisions and level of responsibility over a period of time. However, until relatively recently, credit scores were a closely guarded secret of the lending industry. It wasn't until the age of the Internet that credit scores became easily obtainable and that national legislation was passed to protect consumers from bad information in credit scores. Understanding how credit scores work will help an individual make decisions that will improve their score, and a higher score will lower their cost of borrowing and present new opportunities. Credit scores are used to determine eligibility for loans and interest rates.

Major Factors

Several factors contribute to an overall credit score. More than a third of the score is based simply on whether bills are paid on time. Recent activity is weighted more highly than the past. Though a single missed payment won't destroy a person's credit, every late payment inflicts some damage. Consistently paying all bills on time, including credit cards, ultilities, mortgages, and car loans, will help to keep credit scores high.

Another large contributor to credit scores is the amount of outstanding debt. Even someone who makes all their payments on time can only afford to have so much debt based on their income. The more of that debt that's already been taken out, the less attractive that borrower will be to future creditors, and therefore the lower the credit score will be. Having some debt outsanding and some unused available credit will produce a higher score than having all available credit maxed out.

Other Considerations

The remainder of a credit score is determined by factors such as the length of an individual's credit history, the types of credit they have, and how much new credit they've applied for already. The longer a person has had credit in good standing, the more reliable they're deemed to be, so the higher their score. Similarly, individuals with a mix of credit types, such as credit cards, mortgages, and other loans, the more responsible they're seemed to be by ratings companies. On the other hand, lots of new credit applications often signals financial distress and will automatically lower a credit score.

The exact methodology for calculating credit scores can differ. Several different ratings may be available from different companies, though most lenders might only look at one or two. Different companies may also have access to different information and can occasionally make errors. Frequently obtaining a copy of all credit scores and the contents of the credit reports can help protect against such errors.