What is a Credit Score
A credit score is a numerical representation of an individual’s creditworthiness. Banks and others who lend money or otherwise extend credit are interested in determining the probability of repayment of their funds if they lend to a particular individual. The credit report score is an attempt to quickly and easily tell creditors about the potential borrower. While lenders can go through the individual credit histories of everyone who applies for credit, the credit score is designed to be a proxy for this work and is a representation of all the information contained in a credit history.
There are many different types of credit scores. However one of the most commonly used is the FICO score. The FICO (which stands for Fair Isaac Corporation, the developer of the score) is a weighted calculation of a number of variables in a credit history. FICO scores fall between 300 and 850 with the higher number representing a lower credit risk. The median FICO score is approximately 720. The same individual may have differing FICO credit report scores depending on which credit database is used in the calculation. However the scores will tend to be close to each other if accurate information is being used by the bureaus maintaining the credit databases.
While most of the algorithms behind credit scores are corporate trade secrets, FICO does acknowledge the components of their score and the relative weights given to each constituent piece. The two most important factors in a FICO score are Payment History and Credit Utilization.
Payment history is simply a look at how well an individual has paid their bills. The numbers of delinquent accounts, the type of negative report, as well as the recency of harmful credit events all play a role in how much a credit score is lowered. Bankruptcy, court judgments, liens, or foreclosure all will have a much more damaging effect than a simple late-payment event. And a more recent negative credit event will have a much more damaging impact the same event a number of years previously. The FICO system weighs payment history as making up 35% of their credit rating.
Credit utilization makes up another 30% of a FICO credit report score. One segment is a ratio which shows how much an individual owes compared to how much credit is available. The more debt that is accumulated relative to a person’s total credit limit will raise the credit utilization ratio and will adversely affect the credit score.
The remaining portion of a FICO credit rating is split between three other categories: Length of credit history (15%), types of credit (10%), and new credit inquiries (10%).
The longer an individual’s credit history is, the higher their FICO credit report score will tend to be than someone who has only recently had open credit accounts. The older credit history contains more information for a lender to gauge a borrower’s propensity to repay credit accounts on time.
Creditors also tend to be more comfortable lending to individuals who have a broad mix of types of credit accounts. Successfully managing a blend of revolving credit (e.g. credit cards), installment loans (e.g. student loan, auto loans), consumer finance loans, or mortgages leads to a higher credit report score.
Credit reports also show how often creditors (or potential creditors) have accessed a credit history. It is perceived that an individual who is applying for a large number of new credit lines in a short period of time may be in financial difficulty and be a higher lending risk. More inquiries on a report will cause a decrease in credit rating.
Individuals with high credit scores will find it much easier to be approved for new credit lines and pay lower interest rates than others who have a lower credit rating. Especially during economic turbulence lenders will favor those with high credit ratings significantly more than others. In the modern world access to cheaper credit is a significant advantage and makes financial life easier and potentially more economically rewarding to those with high credit scores.