Credit Scores 101: Understanding Your Credit Score

The days you could get paid in cash and buy everything you needed in cash are long gone. There are a handful of people who manage to get through life without ever having to request a line of credit or apply for a loan. However, the majority of Americans are going to require one of the following loans or lines of credit at least once in their lives:

  • An auto loan.
  • A home loan.
  • A student loan.
  • A business loan.
  • A personal loan for emergencies.
  • Approval for a revolving credit card account.

Many Americans may end up applying for all three throughout the course of their lifetime. Without proper credit history and a decent credit score, you’ll find yourself hard-pressed to get a loan in the first place, let alone manage to secure a favorable interest rate. Without an average or above-average credit score, you may be forced to put your dreams on hold, pay higher rents, and settle for an older vehicle with poor fuel efficiency and increased repair costs.

If you’ve been paying attention to your credit score lately, you’re interested in raising your credit score, or you just want to learn a little bit more about how credit scores are calculated, then you’ve come to the right place! In this article, we’ll be discussing everything that you ever wanted to know about credit scores, from their history to the factors that weigh most heavily on your score. Let’s dive in!

What Exactly Is Your Credit Score?

So, what exactly is a credit score? Since they play such an essential role in our lives, you’d think that more people would understand how credit scores are calculated and what information credit reports typically contain.

Unfortunately, though, the U.S. public education system hasn’t done a lot in regards to credit education. This is why so many young teenagers take on tens of thousands of dollars worth of student loans to go to college without thinking about the consequences. We’re not saying that student loans are bad, but if you don’t have a plan to pay them off, then they can detrimentally impact your credit score for years!

Put simply; your credit score is a three-digit number (usually between 300 and 850) that determines your overall trustworthiness as a borrower. The higher your credit score is, the more trustworthy you are; the lower your credit score is, the less trustworthy you are.

If you have a higher score and represent a lower risk to the lender, you’ll usually be given larger loan amounts and be offered a favorable interest rate so that you won’t pay as much in the long term. However, if your score is lower, many lenders will be hesitant about giving you a loan, to begin with. If you do get a low-credit loan, then you’ll almost certainly be required to pay higher interest rates, which can cost you thousands in the long run.

Credit Scores In The United States

Throughout the early-19th and 20th centuries, loans were typically given out on a case-by-case basis. If you wanted a line of credit or a loan, then you would need to visit a bank and convince them of your worth and your ability to pay back the loan. In many cases, the banks would require you to sign over your farm, land, business, or home as a form of collateral.

As you can imagine, though, this was a very inefficient system and left a lot of room for deception and miscalculation. There was absolutely no way for bankers to determine whether or not an individual was actually trustworthy or not. This meant that loans were scarcely given out unless they were given to an individual who had considerable assets or pre-existing capital.

In 1956, though, Fair Isaac and Company created their revolutionary new credit scoring model to calculate the trustworthiness of consumers. Earl Isaac and William Fair were to friends and business partners who spent their careers studying people’s buying and spending habits.

Using their superior knowledge of American lending and borrowing habits, they created a scoring mechanism that lenders could use to determine whether or not a buyer could be trusted to pay back their loans.

Initially, their system didn’t gain much traction. However, towards the late-1980s (when financing and credit lines were starting to gain popularity), banks finally decided to start incorporating consumer FICO scores into their lending decisions. It wasn’t long before FICO scores became the dominant method of consumer credit scoring, and they’re still used today by over 90% of lenders.

While FICO is definitely the most popular scoring method, the top three credit bureaus (Experian, TransUnion, and Equifax) have each developed their own credit scoring algorithm to compete with FICO. Their joint solution is known as the VantageScore and usees the same 350-850 numerical scale as the FICO score.

While the VantageScore is gaining traction across the country, FICO scores are still the dominant scoring method used to determine borrower eligibility.

The Difference Between Your Credit Score And Credit Report

If you’re applying for a loan, then you’ve likely heard the terms credit score and credit report used interchangeably with one another. Although the two terms are linked to each other, they are each quite different from each other regarding the information they contain regarding your overall credit profile.

Your credit report is a detailed report of your credit profile. Each of the three bureaus will have an itemized list of every loan you’ve taken out in recent years, current loans that you’re paying off, the number of open bank and credit accounts you have in your name, and your payment history on each account.

Your credit score is calculated based on all of the contributing factors found in your credit report. The more positive your credit report is, the higher your score will be. The more negative and delinquent your credit report appears to be, the lower your score will be.

Why Do I Have Three Different Credit Scores?

If you’ve been using a credit monitoring service or have been examining your free annual credit reports, then you may have noticed that you have three different FICO credit scores. Although each bureau uses the same FICO algorithm to calculate your score, keep in mind that each bureau may have a separate report on your profile.

You may have a different credit report with each bureau because some creditors and lenders may only report to one or two of the bureaus, while other lenders will send a report to all three of the bureaus. No regulation requires lenders to send reports to all bureaus, so some lenders just send reports to one to save time and energy.

This, in turn, means that you’ll likely have a different score with each bureau. If your score with each bureau is the same, then that means your report is the same with each bureau. While this is unlikely, it is possible.

Additional Scoring Models Used To Calculate Credit

The two most popular scoring models used by lenders are the FICO score and the VantageScore. However, each of the three major bureaus has its own perspective scoring algorithm that they use in addition to FICO and VantageScore:

  • Experian uses the Experian Risk Score.
  • Equifax uses the Beacon and Pinnacle models.
  • TransUnion utilizes its Empirica scoring model.

While these additional scoring methods aren’t quite as commonly used, there may be some lenders who do use them, so it’s important to at least know what they are so you’re not taken by surprise.

Additionally, if you’re applying for health or auto insurance, then you may be vetted by your credit-based insurance score. This number is usually similar to your FICO score but contains information that’s used to determine what type of monthly premiums and deductibles you qualify for in regards to your insurance policy. Since your credit score is often taken into consideration when applying for auto and health insurance, it really does pay to have a positive score reflected by your credit report.

The Most Important Factors In Your Credit Score

So, now that you understand a little bit more about how credit scores came about and what credit scores represent, it’s time to discuss how your credit score is calculated. Understanding the weight that each of the following factors has on your credit score is vital if you want to increase your credit score or repair a bad credit score.

If you can stay on top of these factors, then you’ll be well on your way to building a solid credit score that will help you secure low-interest loans in the future. Let’s take a look!

1- Your Credit Payment History

Your payment history is, by far, the factor that weighs most heavily on your credit score. It makes up for around 35% of your entire FICO score. This factor tracks your record of payments made on time as well as missed payments, default accounts, and settled accounts.

2- Your Credit Utilization

Your total credit utilization accounts for 30% of your credit score and is almost as important as your credit payment history. This is calculated by comparing your total revolving credit lines to how much you’ve used from each credit line. Optimally, you should aim to use less than 30% of your available credit if you want to maintain a good score.

3- The Age Of Your Credit

Your credit report’s age only accounts for 15% of your FICO score. However, it’s still an important factor worth noting. Essentially, the longer you have accounts open, the better your credit age looks. This means that it’s a good idea to keep old bank accounts and credit card accounts open to increase the average age of your accounts.

4- The Type/Variety Of Your Credit

The variety of credit on your score accounts for 10% of your credit score. This factor balances what type of accounts are on your credit score. Generally speaking, the more variety you have (auto loans, credit cards, personal loans, mortgage, etc.), the better it looks for your credit score.

5- Number Of New Credit Applications On Your Report

The number of hard pulls on your credit profile makes up for 10% of your credit score. Whenever you apply for a loan or a credit card, the lending institution performs a “hard pull” on your account to view your credit score and report. The more pulls that are listed on your account, the more desperate you seem and the lower your resulting credit score will be. Keep in mind that hard pulls are usually removed from your account within two years.

Managing Credit Risk Factors

Now that you’ve had a chance to see the top five factors that weigh most heavily on your credit score, it’s time to discuss managing these risk factors. If you’re not careful, it can be very easy to let your credit score get out of hand and find it plummeting lower with each passing month.

In this section, you’ll find some helpful tips to help you manage your credit risk factors so that you can maintain your good credit score or even boost your below-average credit score. As long as you take consistent efforts to build and improve your risk factors each month, then you’ll be on track with your credit score goals.

Credit Score And Payment History

Credit payment history accounts for 35% of your credit score.

As we mentioned above, your payment history weighs heavier than all of the other factors on your credit score. This means that it’s vital to keep up with your monthly payments, no matter how trivial. Missed payments and default accounts (unpaid loans that have been passed to collections) can have a detrimental effect on your credit score.

These negative marks will remain on your credit for up to seven years at a time, meaning that missed payments can negatively impact your score for almost a decade! Conversely, if you have a good history of making your payments on time every month, this will positively affect your credit report and score.

How Credit Utilization Affects Credit?

Credit utilization accounts for 30% of your credit score.

While your credit payment history is relatively straightforward, many consumers remain in the dark or confused about how their credit utilization affects their credit score. Credit utilization is a factor that keeps track of the percentage of your available revolving credit that you’re utilizing. Revolving credit is an open loan account that can be used and paid off at your discretion, such as a credit card. Credit utilization is calculated on a month-by-month basis, so it’s important to stay on top of it.

Here’s an example:

Let’s say that you have two open credit card accounts that each have a $5,000 limit. This means that your total available revolving credit is $10,000. In order to keep your credit utilization below 30%, then you’ll need to make sure that you don’t spend more than $3,333 (30% of $10,000). Credit accounts send your current revolving balance to the credit bureaus each month, so make sure that your utilization is below 30% within a week before your monthly invoice is sent out.

This means that it’s okay to spend your entire $10,000 limit as long as you pay off 70% of that before your next invoice is sent out. This is essential if you want to maintain a positive credit score.

How To Maintain Healthy Credit Age?

Credit age accounts for 15% of your credit score.

The reason why credit age is important is that it represents a healthy financial life. This means that the longer you have certain accounts open, the more positive of an impact that it will have on your score. If you’re 30-years-old and you still have the same credit card account open from when you were 20, then you’ll have a 10-year-old account on your credit report (which looks great!).

Conversely, if you’re constantly closing old accounts and opening new accounts, then it will likely hurt your credit score. It shows that you’re the type of person who jumps from one account to another and means that you’re a riskier consumer who isn’t as careful or selective about their spending and account status.

How Do Credit Inquiries Affect My Score?

Credit inquiries account for 10% of your credit score.

The number of credit inquiries you have on your credit report is a strong indicator of how trustworthy a borrower you are. Every time that you apply for a loan, a “hard pull” is performed on your credit profile by the lender so that they can view your report and your latest credit scores. Each pull can temporarily decrease your score by a few points, and the more pulls you rack up in six months, the worse of an effect it will have on your credit.

Essentially, if you go to five different lenders in a month and apply for a loan or credit account, then it makes you look like you’re a desperate borrower who is frantically searching for a loan. Stressed borrowers often have a lower likelihood of making their monthly payments on time and therefore represent a higher risk for lenders.

Keep in mind that each hard pull on your credit stays on your report for two years. This means that as long as you’re practicing safe borrowing habits, maintaining your old revolving credit accounts, and you’re not constantly applying for new loans that you should maintain a decent credit rating.

Why Debt Diversity Is Important?

The diversity and type of loans listed on your credit report account for the remaining 10% of your credit score.
Generally speaking, it’s considered better to have a variety of different types of debt listed on your account. For instance, a diverse credit report would show that you have paid or are paying accounts such as:

  • A revolving credit card.
  • A personal loan.
  • An auto loan.
  • A home loan (mortgage).

Essentially, the greater the variety of debts that you have listed on your credit report, the more trustworthy you appear to lenders. Debt diversity shows that you are a competent borrower and that you have experience managing and paying different types of debts and loans.

Conversely, if you’ve only ever had credit cards or you’ve only ever had personal loans, then it can be a red flag for creditors. It could mean that you don’t have experience with certain types of debt and therefore aren’t ready to take on the burden of new debt.

Staying On Top Of Your Credit

Alright, so far, we’ve discussed the history and importance of your credit score as well as the main factors that determine what your credit score is. Now that you have a better picture of how your credit score is calculated and how important it is to maintain it, let’s discuss how to stay on top of your credit so that you’ll never be caught off guard by a negative credit mark or an unexpectedly low credit score rating.

The more information you know about your personal credit score and credit usage, the better position you’ll be in to determine your eligibility for loans without performing a hard credit pull.

Monitoring your credit is also a good way to ensure that your lenders don’t send inaccurate reports to credit bureaus. This can often happen by mistake and you have a right to challenge any and all erroneous or falsified claims on your credit report.

How To Get Your Free Credit Report

In 1970, the United States Free Trade Commission passed the Fair Credit Reporting Act. Among other things, this report solidified that every consumer has a legal right to review their credit report from all three bureaus once every twelve months (annually). In order to view your annual credit report, you can visit https://www.annualcreditreport.com/index.action.

Once you complete the request, you’ll be able to view your credit reports through your online portal. This is a great way to check your payment progress and history. It’s also a good way to check if there are any mistakes or misreported items on your credit report.

Paid Credit Monitoring Services

While it’s your legal right to get your free annual credit report, the bureaus are not required to provide you with your FICO score. This means that in addition to receiving and viewing your annual report, you’ll also benefit from using a paid credit monitoring service. The most popular credit monitoring services are usually those that the three main bureaus list:

  • Experian
  • TransUnion
  • Equifax

However, there are also a number of third-party credit monitoring services that can help you keep track of your score and even help you with your monthly budgeting, spending and let you know about any credit notifications on your account.

Are There Free Credit Monitoring Services?

Typically, most credit monitoring services will charge you a monthly fee between $5 and $30 per month. However, some credit monitoring services will provide you with a free or light version of their reporting service that will allow you to view your credit score. However, these light versions typically won’t give you a full picture of your credit score or allow you to review your bureau reports.

In addition to credit monitoring services, certain credit cards (such as Capital One and Discover) will keep you updated on your latest FICO score. Again, they won’t be able to give you a full breakdown of your credit report, but being able to view your score on a monthly basis for free is definitely a useful perk.

How Credit Scores Have Changed 2020-2021

Traditionally, credit scores and credit reporting have been fairly set in stone. However, the past few years have seen a number of changes in the way that consumers’ credit scores are calculated and which debts weigh the heaviest on their credit scores. Below, we’ll show you some of the most recent changes to score calculation that could affect your credit score.

Less Impact From Medical Debts

If you have default medical bills due to complications with your health insurance provider, then you can now get these negative marks removed from your credit instantly. Even if your unpaid medical debts aren’t the result of an insurance error and are the result of personal error, they will still weigh less than they did in previous years. This is due primarily in part to updates made to the FICO scoring system in the latest FICO Score 9 and the VantageScore 4.0.

Tax Liens No Longer Display On Your Report

As of 2018, credit bureaus are no longer allowed to report government tax liens on your consumer credit reports. This is great news for people who owe money to the IRS or their local state governments.

Prior to this change in the scoring procedure, having a tax lien on your account could reduce your credit score by anywhere between 30 and 50 points. If you do find an old tax lien listed on your account, then you have a right to contest it and get it permanently removed from your credit report.

Default Loans Under $100 No Longer Display On Your Report

Another great update to the FICO 9 scoring system is that default loans that are less than $100 are no longer taken into account for your credit score.

UltraFICO Score: How It Applies To Your Credit Report

UltraFICO is a new scoring model that is being developed and refined. The new scoring model would hypothetically make it easier for those who have a poor previous credit history to apply for loans based on their current financial activity instead of their past mistakes.

Obviously, it could take a while before this new UltraFICO scoring model is used widely, but it’s a good thing to keep an eye out for.

Which Credit Score Do Lenders Use The Most?

The simplest way to see which model your credit score will be based on is to ask the lender which scoring model that they typically use. That being said, the most commonly used scores that creditors use are the FICO 8 score and the VantageScore 3.0.

Although FICO 9 and VantageScore 4.0 have been fully refined and developed, they have yet to achieve widespread use by most financial institutions. Once they do become more prevalent in the coming years, then many consumers will find that their scores are a bit higher than they previously were.