How Credit Scores Work: A Complete Guide

Your credit score is a three-digit number that represents your creditworthiness to lenders, landlords, and other entities that may extend you credit or services. Understanding how credit scores work is the first step toward taking control of your financial future. This comprehensive guide explains everything you need to know about credit scoring, from the basic calculations to advanced strategies for improvement.

What Is a Credit Score?

A credit score is a numerical representation of your credit risk based on information in your credit report. Lenders use this score to quickly assess the likelihood that you will repay borrowed money. The most widely used credit scoring model is the FICO Score, though VantageScore is also commonly used by many lenders.

Credit scores typically range from 300 to 850, with higher scores indicating lower credit risk. A score above 700 is generally considered good, while scores above 800 are considered excellent. These numbers directly impact the interest rates you receive, whether you qualify for loans, and even non-lending decisions like apartment rentals and insurance premiums.

The Five Factors That Determine Your Credit Score

FICO scores are calculated using five main categories of information from your credit report. Understanding these factors helps you focus your efforts on what matters most for improving your score.

1. Payment History (35%)

Your payment history is the single most important factor in your credit score, accounting for 35% of the calculation. This includes on-time payments, late payments, missed payments, and accounts sent to collections. Even one late payment can significantly impact your score, especially if you otherwise have excellent credit. The more recent the late payment, the more it hurts your score. If you have late payments on your credit report, professional credit repair may help remove inaccurate entries.

2. Credit Utilization (30%)

Credit utilization refers to how much of your available credit you are using at any given time. This factor accounts for 30% of your score. Experts recommend keeping your utilization below 30%, but those with the highest credit scores typically use less than 10% of their available credit. This ratio is calculated both for individual cards and across all your revolving accounts combined.

3. Length of Credit History (15%)

The length of your credit history makes up 15% of your score. This includes the age of your oldest account, the age of your newest account, and the average age of all your accounts. Generally, a longer credit history results in a higher score. This is why closing old credit cards can sometimes hurt your score, even if you no longer use them.

4. Credit Mix (10%)

Having a diverse mix of credit types demonstrates that you can manage different kinds of debt responsibly. This factor accounts for 10% of your score and includes revolving credit (credit cards), installment loans (auto loans, mortgages), and retail accounts. You do not need to have every type of credit to achieve a good score, but having experience with multiple types can help.

5. New Credit Inquiries (10%)

New credit applications and hard inquiries make up the final 10% of your score. Each time you apply for credit, a hard inquiry is recorded on your report. Too many inquiries in a short period can signal that you are desperate for credit, which is seen as a risk factor. However, multiple inquiries for the same type of loan (like mortgage shopping) within a short window are typically counted as a single inquiry. If you have unauthorized hard inquiries, these can be disputed and removed.

Credit Score Ranges Explained

Understanding where your score falls within the credit score ranges helps you know what to expect when applying for credit:

• Exceptional (800-850): You qualify for the best interest rates and terms available. Lenders view you as a very low-risk borrower.
• Very Good (740-799): You qualify for better-than-average rates and have access to most credit products.
• Good (670-739): You are considered an acceptable borrower and can qualify for most loans, though not at the best rates.
• Fair (580-669): You may have difficulty getting approved for some credit products and will pay higher interest rates.
• Poor (300-579): You will have difficulty getting approved for most credit products and may need to use secured cards or specialized lenders.

How to Check Your Credit Score

You can check your credit score through several free services. Many credit card companies and banks now offer free credit score access to their customers. You can also use services like Credit Karma, Credit Sesame, or get your official FICO score from myFICO.com. Under federal law, you are entitled to one free credit report from each bureau annually through AnnualCreditReport.com.

Strategies to Improve Your Credit Score

Improving your credit score takes time and consistent effort, but the following strategies can help accelerate your progress:

• Pay all bills on time: Set up automatic payments or reminders to never miss a due date.
• Reduce credit card balances: Pay down existing debt to lower your utilization ratio.
• Keep old accounts open: Maintain the length of your credit history by keeping old cards active.
• Limit new applications: Only apply for credit when necessary to avoid excessive inquiries.
• Dispute errors: Review your credit reports regularly and dispute any inaccurate information.
• Become an authorized user: Being added to a responsible person's credit card can help build your history.

Common Credit Score Myths

There are many misconceptions about credit scores. Here are some common myths debunked:

• Myth: Checking your own credit hurts your score. Fact: Checking your own credit is a soft inquiry and does not affect your score.
• Myth: You only have one credit score. Fact: You have multiple scores from different scoring models and bureaus.
• Myth: Closing credit cards always helps your score. Fact: Closing cards can hurt your utilization ratio and average account age.
• Myth: Income affects your credit score. Fact: Income is not a factor in credit score calculations.
• Myth: Carrying a balance improves your score. Fact: Paying in full each month is better for your finances and score.

Get Help Improving Your Credit Score

If negative items on your credit report are holding back your score, professional credit repair can help. At The Credit Repair Guy, we specialize in identifying and disputing inaccurate, unverifiable, or unfair items on your credit report. Schedule your free consultation today to learn how we can help you achieve the credit score you deserve.