How Credit Scores Work: What Really Matters
Your credit score can influence whether you're approved for financing and the terms you're offered.
But a credit score isn't created randomly.
Credit scoring models analyze information contained in your credit reports and use that information to estimate credit risk.
Different scoring models can calculate scores differently, but understanding the major factors behind your scores can help you make better credit decisions.
Here are 5 major areas you should understand.
1. Payment History
Payment history is one of the most important parts of many credit scoring models.
Creditors want to see whether you've handled your obligations as agreed.
Your credit reports may contain information about:
On-time payments
30-day late payments
60-day late payments
90-day or greater delinquencies
Collections
Charge-offs
The longer an account remains delinquent, the more serious the situation can become.
One of the strongest habits you can develop is simple:
Pay your accounts on time, every time.
2. Amounts Owed and Credit Utilization
How much debt you're carrying also matters.
For revolving accounts such as credit cards, an important measurement is credit utilization.
Suppose you have:
Credit Limit: $10,000
Reported Balance: $5,000
You're using approximately 50% of the available credit on that account.
Generally, lower revolving utilization can be better for credit scoring than higher utilization.
Remember that both your overall revolving utilization and utilization on individual accounts may matter.
You don't need to carry a balance or pay interest simply to build a credit score.
3. Length of Credit History
Credit scoring models can consider how long you've been managing credit.
That may include factors such as:
The age of your oldest account
The age of your newest account
The average age of your accounts
This is one reason opening and closing accounts should be done strategically.
Older established accounts can contribute valuable history to your credit profile.
That doesn't mean you must keep every account forever, but don't close an established account without understanding the possible consequences.
4. New Credit
Opening several accounts within a short period can affect your credit profile.
Applying for new credit can result in a hard inquiry, depending on the situation.
Opening new accounts can also reduce the average age of your accounts.
This doesn't mean you should never apply for new credit.
Instead, apply with a purpose.
Before applying, know:
Why you need the account
Whether you're reasonably likely to qualify
How the account fits your financial plan
More credit isn't automatically better credit.
5. Credit Mix
Credit reports can contain different types of accounts.
For example:
Credit cards
Auto loans
Mortgages
Personal loans
Student loans
Scoring models may consider your experience managing different types of credit.
But don't take out unnecessary loans just because you're trying to improve your “credit mix.”
Paying interest on debt you don't need simply to chase credit-score points usually doesn't make financial sense.
Your Credit Score Can Change
Your credit score isn't permanently fixed.
As information on your credit reports changes, your scores can change too.
Balances change.
Accounts age.
New accounts appear.
Payments are reported.
Negative information may eventually age off.
That's why you may see your score move even when you haven't done anything dramatic.
Also remember that you don't necessarily have only one credit score.
Different lenders may use different scoring models and different versions of those models.
The score you see through a consumer monitoring service may therefore differ from the score a particular lender uses.
Focus on the Credit Profile — Not Just the Number
It's easy to become obsessed with gaining or losing a few points.
Instead, focus on building a stronger overall credit profile.
Pay on time.
Keep revolving balances manageable.
Apply for credit strategically.
Maintain established accounts when appropriate.
Review your credit reports for inaccurate or unfamiliar information.
You can't control every scoring calculation.
But you can control many of the financial habits that influence the information being reported about you.
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