How Credit Scores Work

Apr 28, 2019

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Credit scores consist of a three-digit number, usually between 300 and 850, designed to represent the likelihood that you’ll repay a loan on time. They’re also a little mysterious and that’s not an accident. The major credit-scoring companies, FICO and VantageScore, keep their formulas secret, so only a handful of people know the exact recipe that’s used to turn your credit history into a credit score.

Nevertheless, the credit scoring companies release enough information that experts are largely able to determine how these formulas work. Here’s what you need to know.

Credit scoring basics

Credit-scoring models use a person’s credit history from one of the three major consumer credit bureaus, Experian, Equifax and TransUnion. Before credit scores existed, a lender would have to pull a copy of your entire credit report and then analyze it to determine your creditworthiness. But now, they just receive a single number from one of the bureaus not subject to multiple interpretations.

With FICO scores:

  • 300-579 is Very Poor.
  • 580-669 is Fair.
  • 670-739 is Good.
  • 740-799 is Very Good.
  • 800-850 is Exceptional.

With VantageScore:

  • 300 – 549 is Very Poor.
  • 550-649 is Poor.
  • 650-699 is Fair.
  • 700-749 is Good.
  • 750-850 is Excellent.

What your credit score consists of

FICO is relatively forthcoming about the factors that make up its credit-scoring models.

Payment history. 35% of a FICO score is made up of your payment history. If you get behind in making loan payments, the longer and more recent the delinquency, the greater the negative impact on your credit score.

Amounts owed. 30% of your FICO score consists of the relative size of your current debt. In particular, your debt-to-credit ratio is the total of your debts divided by the total amount of credit that you’ve been extended, across all accounts. Many people claim that it’s best to have a debt-to-credit ratio below 20%, but it’s not a magic number.

Length of credit history. 15% of your score is based on the average length of all accounts on your credit history. This becomes a significant factor for those who have very little credit history, such as young adults, recent immigrants and anyone who has largely avoided credit. It can also be a factor for people who open and close accounts within a very short period of time.

New credit. 10% of your credit score is determined by your most recent accounts. Having recently opened too many accounts will have a negative impact on your score, as the scoring models will interpret this as a sign of possible financial distress.

Credit mix. 10% of your score is related to how many different types of credit accounts you have, such as mortgages, car loans, credit loans and store charge cards. While having a larger mix of types of loans is better than having fewer, no one recommends taking out unnecessary loans just to boost your credit score.

How to boost your credit score the traditional way

The way to improve your credit score is to focus on its two most important factors: payment history and amounts owed. Consistently paying your bills on time is the most important way to improve your credit score. Thankfully, most lenders won’t report delinquencies less than 30 days old, and many won’t even report payments that are 30 to 60 days late. But once you get beyond 60 days, each late payment will have a dramatic effect on your credit score.

That’s why it’s vital that you use every necessary resource to make all of your payments on time. This includes setting up alerts and reminders, as well as implementing automatic payments from credit-card issuers and other lenders. Nearly all credit cards offer these features.

Next, you want to lower your debt-to-credit ratio. This is the total amount of debt you have divided by the total amount of credit that you’ve been extended, across all accounts. So the two ways to decrease your debt-to-credit ratio are to decrease your debt and to increase your credit. This is why applying for a new credit card can actually help your credit score. Increasing your available credit, either through existing accounts or by opening a new account, will always decrease your debt-to-credit ratio — if you don’t take on more debt.

When it comes to credit cards, one quirk about debt is that your statement balances are reported to the credit bureaus as debt, even when you avoid interest by paying your balance in full each month. So if you charge a lot on your cards, your credit report could show significant amounts of debt, even if you don’t think of it that way. Therefore, you may wish to pay off much or all of your balance before your statement closing date. For more information, read my post on Important Dates for Your Credit Cards.

After those two factors, the next most important thing you need to remember is not to open up lots of new credit card accounts or other loans in a short amount of time. It’s not that card issuers don’t want to offer you lots of points and miles, it’s that they don’t want to loan money to someone who appears to be seeking lots of new loans. Applying for many new accounts makes you look like someone who’s facing serious financial problems and may soon start defaulting on loans.

Correcting errors

Another potential way that you can improve your credit score is to correct any errors in your credit history. You can request credit reports for free from the three major credit bureaus through annualcreditreport.com, which is the only site authorized by federal law to provide you with a truly free credit report. While it’s outside the scope of this post, there are ways to dispute erroneous information on your reports due to identity theft or errors. Just be skeptical of companies that offer to remove legitimate information for a fee.

Asking for forbearance

When you’ve made a mistake that’s had an impact on your credit report and credit score, it’s possible that you can ask the lender to remove the negative information. Simply call or write the lender, explain your mistake, and politely request that they amend your credit history to remove the record. In my experience, this works best for minor mistakes on an account with an otherwise spotless payment record. And before asking for forbearance, make sure that your account is no longer delinquent.

Experian Boost

Experian, one of the three major consumer credit bureaus, recently began offering a new way to increase your credit score called Boost. This free service allows consumers to voluntarily include information from their payments to mobile phone companies and other utilities in their credit score. Experian Boost is primarily designed to help customers with a limited credit history establish their creditworthiness more quickly. And unlike any other aspect of your credit history, you have complete control over what you want to include and what you want to leave out.

Just note that lenders will only see the effects of Boost if they view your Experian credit report or pull your FICO 8, FICO 9, VantageScore 3 or VantageScore 4 credit scores, and are using Experian data. Boost has no effect on other scoring models or any scores that use your Equifax or TransUnion credit histories.

Common misconceptions about credit scores

1. There’s some quick fix out there for bad credit. Like ads for magical pills that supposedly allow you to lose weight without diet and exercise, there are plenty of people who claim to have discovered (and will try to sell you) a quick fix for bad credit. The truth is that you have to pay your bills on time and carry very little debt. If you do those two things and you have a significant credit history, then it’s impossible not to have a great credit score. But if you have a record of late payments and a high level of debt, there’s no way to immediately have good credit.

2. Focusing on a single credit score. One big mistake people make when talking about this subject is referring to someone having a single credit score, kind of like their age or their height. In fact, there are numerous credit-scoring models offered by both FICO and VantageScore. Some are used for different purposes such as mortgages, car loans and credit card applications, while others are just older formulas.

Furthermore, a lender can pull an applicant’s credit history data from any of the three major consumer credit bureaus and come up with a different result from each one. So when you look at a credit score, always keep in mind that it’s one of many and it may or may not be the one a particular lender is using.

3. Worrying about your oldest account. While your average account age is a minor factor in your credit score, I’ve heard many people proclaim that you must not close your oldest account. That’s nonsense, since the closed account will continue to appear on your credit history and be factored into your average account age. Whenever someone tells you that there’s some way to improve your credit by keeping an account open, or closing it, just keep in mind that an account doesn’t disappear from your credit history just because you closed it.

4. Fewer credit cards are better. Like many award-travel enthusiasts, I have numerous credit card accounts. In response to hearing that, some conclude that my credit must be terrible. They might be surprised to learn that I have excellent credit not despite my numerous accounts, but because of them.

Each account, when managed responsibly, adds positive information to my credit history and helps me to maintain my high credit scores. So if you have little-used accounts with no annual fee, there’s really little reason to close them. Look at it from the lender’s perspective: Do you think they would rather offer a new line of credit to someone with a very limited record of paying back loans, or someone with a very extensive history of managing credit responsibly?

5. 0% is the ideal credit utilization ratio. By never using your credit cards or by paying off your balances before the statement closes, it’s possible to have a credit report that shows 0% utilization. But, it’s actually better to have a very low utilization ratio as opposed to 0% utilization. Again, the credit scoring models favor those who use credit responsibly over those who don’t use it at all.

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