Credit Scores: How Do They Work?

a wood cut out of a house with credit score written on it with terms like financial, amounts, term, decrease, income, and rate.

To generate your first credit score, your credit report will have to have at least one account on which you make monthly payments. The time it takes for your first score to show up will vary based on the credit score model.  For example, the VantageScore model will create your first score in one or two months, while a FICO score will take up to six months.

Credit scoring is a statistical method that lenders, some insurance companies, and employers use to quickly and objectively assess the credit risk of an applicant. In the case of an employer, they often use the report to assess your character and to look for outside influences that could affect your work ethics.

The score is a number that rates the likelihood you will pay back a loan. Different industries will rank a score differently, but in general, a score of 300 is considered high risk, while 850 is considered low risk. Your credit score is calculated with information from your credit report using a complicated mathematical algorithm. Each time your credit report and score is ordered, it is recalculated. This is sometimes referred to as a credit score model. There are hundreds of credit score models used on credit reports. This is why credit scores don’t always match from one lender to another.

When your credit score is calculated, the model considers both positive and negative information on your credit report, such as how you pay, how much of your credit lines you use, how old your credit is, the balances of your credit, and more.

Credit scores do not consider your income, savings, down payment amount, or demographic factors such as gender, race, nationality, or marital status.

Key Factors That Make up Your Credit Score

Below are most common factors that make up how your credit score is calculated. These factors do vary slightly between credit score models, but in general, they are all very similar.

  • 40% – Your payment history, which most people mistakenly think makes up the majority of their credit score.
  • 21% – Depth of credit or the mix such as a home loan, auto loan, and credit card.
  • 20% – Utilization of your credit limits.
  • 11% – Balances on your active credit.
  • 5% – Recent credit you opened or applied for, called inquires.
  • 3% – Available credit that you are not using.

The most important factor for a good credit score is paying your bills on time. Even if the debt you owe is a small amount, it is crucial that you make payments on time. Additionally, you may want to keep balances low on credit cards and other revolving credit.  Apply for and open new credit accounts only when needed and when they can be paid down. And pay off debt rather than moving it around. Also, don’t close unused cards as a short-term strategy to raise your score. Owing the same amount but having fewer open accounts may lower your score.

Shopping for a home or car loan? If you have applied for a home or auto loan within the past 365 days, these inquiries are only ignored on your report for the first 30 calendar days. Multiple inquiries within the 14 days following the 30-day grace period are counted as one inquiry that will show up on your report. Too many inquiries can hurt your score, which can severely limit your buying power.

A very common question from people is “why isn’t my score higher?” or “what can do to improve my score?”

This is most often followed by advice from neighbors, friends, and the grocery clerk.  Most often, the advice is opinion based and even just wrong. Every score is accompanied by a maximum of four factors. Also called “reason codes,” these factors are provided by the credit bureau providing the score and are the most significant reason your score was not higher. Depending on the credit score model being used, there can be 100 or more possible codes. Sample factor codes may include: “balances are too high,” “too many retail accounts” and “late payments are affecting the score.” Generally, the factors are listed in their prioritized order of impact to your score from top to bottom. Generally, the use of these codes is the most effective method of managing your credit score. If your score is already over 800, the codes have less impact on your score because you’re already considered low risk.

Article written by
Melinda Opperman
Melinda Opperman is an exceptional educator who lives and breathes the creation and implementation of innovative ways to motivate and educate community members and students about financial literacy. Melinda joined in 2003 and has over two decades of experience in the industry.

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