How Does a Credit Score Really Work?
Published: March 12, 2021
Revised: December 22, 2021
There are many pieces to a strong financial plan: creating a budget, paying off debt, saving money for emergencies and building wealth for the long term.
So where does the credit score fit in?
First off, let’s be clear that the credit score has zero correlation between your score and the amount of money you have.
There is a common myth circulating around that the higher your score, the wealthier you are. However, this is completely false. In fact, if you stopped borrowing money for ten years or more, your credit score would completely disappear.
You could have ten million dollars in the bank and yet you wouldn’t have a credit score at all.
What is a Credit Score?
Your credit score is a representation of your behavior with borrowing money and is used by potential lenders to determine your level of risk before they lend you money.
A higher score shows lenders you are a low-risk borrower and a lower score shows lenders you are a high risk borrower.
Those who are considered low risk to a lender will receive better loan terms and lower interest rates. The difference between a high score and low score could end up saving (or costing) you tens of thousands of dollars!
How is Your Credit Score Calculated?
How your credit score is calculated matters more than you may think. In fact, there are five different ways your credit score is calculated and each way is weighted differently.
A common mistake borrowers make is focusing too much on the area that makes up the least portion of their score and not paying enough attention to the area that makes up the bulk of their credit score.
Below are the five different factors of a credit score listed in order of highest importance to lowest.
Payment History (35%)
Think about this: if you were lending money to a friend, wouldn’t you want to know how well they are at paying their bills on time?
This is why payment history tops the list and makes up 35% of the overall credit score. The best way for lenders to trust someone is to take a look at their history of borrowing money and paying it back on time.
In fact, one missed payment will stay on a credit report for seven years!
Amounts Owed (30%)
The second thing lenders want to see is how much debt someone has compared to the amount they have available to borrow.
This is also known as the credit utilization limit and it’s calculated by revolving credit.
Revolving credit is the type of credit that is always open. These are credit cards, a home equity line of credit (HELOC) or a gas station card. With revolving credit, as soon as the loan is paid off, a borrower can immediately draw on that same line of credit, hence why it’s called revolving credit.
The other type of credit is called an installment loan. This is a loan with a fixed term, usually in months. Once the borrower pays off an installment loan, it is automatically closed and cannot be drawn from again. Examples of installment loans are mortgages, auto loans and student loans.
Lenders like to see a lower credit utilization percentage because it shows the borrower is responsible with managing their credit.
Let’s assume John has a revolving credit limit of $25,000 and his current balance is only $1,000. This equals a credit utilization of 4% and it also shows potential lenders his ability to keep a low balance as compared to the amount he could actually borrow.
On the other hand, let’s assume Sara has the same credit limit but a balance of $20,000. Because she’s closer to her credit limit and her credit utilization is 80%, this tells potential lenders she is a higher risk.
What is a Good Credit Utilization?
To calculate the credit utilization, simply divide the current revolving credit balance by the revolving credit limit.
If there’s a credit limit of $20,000 and the current balance is $2,000, then the credit utilization is 10%.
A good rule of thumb is to keep the credit utilization below 30%, however MyFICO recently reported that those with a credit score of 785 or higher had a credit utilization of 7%.
Length of Credit History (15%)
Credit history is actually based on the following three factors:
- How long someone has had their credit accounts, including the age of their oldest, their newest, and then an average for all of their accounts
- How long someone has had specific credit accounts
- How long it’s been since someone used certain accounts
For lenders, a longer credit history gives lenders a better idea of a borrower’s behavior with borrowing money.
However, this is not nearly as important as payment history or the amount owed. Length of credit history only makes up 15% of the overall credit score, whereas payment history and amounts owed make up a whopping 65% of the total credit score.
Credit Mix (10%)
Lenders also like to see how well someone is at managing all different types of credit. If a lender can see the borrower is able to manage a mortgage, a student loan, and a credit card, then this makes the borrower less of a risk to a potential lender.
Keep in mind this factor only makes up 10% of the credit score and is not nearly as important as payment history and amounts owed.
New Credit (10%)
Rounding at the last factor of your credit score is new credit. New credit is a tricky one because it can both increase and decrease the overall credit score.
Whenever a borrower applies for new credit, a lender will make a “hard inquiry” which will lower the score by a few points for a brief period of time. Also, whenever new credit is added, the average age of all credit accounts decreases, and thus negatively affects the credit history factor.
However, new credit may also add a new type of credit, which would then improve the overall credit mix. And don’t forget, adding a new revolving credit account would decrease the credit utilization percentage, thus improving your overall score again.
As mentioned above, this is certainly a factor, but only a small factor when compared to the bulk makeup of the credit score.
What is a Good Credit Score?
Credit scores range from the 300 all the way up to a perfect credit score of 850.
Exceptional Score (800-850)
An exceptional score gives borrowers the best loan terms, largest credit limits and the lowest interest rates.
One thing to remember is a perfect credit score of 850 will be treated the same as a credit score of 815. Only 21% of Americans fall into the “exceptional score” range.
Very Good Score (740-799)
Twenty-five percent of Americans fall into this category. A very good score still gives borrowers above average rates and better loan terms.
Good Score (670-739)
A good score will still give borrowers good rates, but not always the best. Twenty-one percent of borrowers fall into the “good” range and 8% of this group will become delinquent borrowers.
Fair Score (580-669)
Once the score drops below 670, a borrower is considered high risk to lenders. People in this range are considered subprime borrowers and will have a harder time getting loans approved. However, if approved, the borrower can expect higher interest rates than those with good, very good or exceptional scores.
Currently only 17% of Americans are within the “fair score” range.
Very Poor Score (300-579)
Any borrower with a score below 580 will most likely be denied credit. This score represents a very risky borrower with a history of missed payments and poor borrowing behavior.
If someone is approved within this range, they may have to pay an upfront fee or deposit to have access to credit. If someone finds themselves within this range, it would be best to focus on improving the score before applying for credit.
As you can see, there are many factors that determine your credit score. Focusing on the factors that make up the largest percentage of your credit score will help you improve and maintain a better score.
Improving your score before applying for a loan can result in tens of thousands of dollars in savings. For example, if you were to purchase a $350,000 mortgage on a 30-year loan, the difference between a 3% and 4% rate is over $70,000 over the life of the loan.
Just like creating a budget, paying down debt, and saving money is critical to a strong financial plan, the credit score is also an important part of your personal finances.
Chris “Peach” Petrie is the founder of Money Peach. Money Peach partnered with OneAZ to provide free financial education to members across the state. To learn more about OneAZ’s partnership with Money Peach, click here.
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APR = Annual Percentage Rate