What exactly is a credit score and how does it work?
By Jenesy Gabrielle Burkett Fox
We’re often told to start building our credit young. If not from our parents or academic institutions, we hear our friends vaguely talking about building credit or improving their credit scores. But what the hell is a credit score? This article dives into what credit scores are, understanding your credit score and where you can find your credit score.
What is a credit score?
A credit score is a tool used by financial institutions to assess the risk involved with lending an individual money. Credit scores are important because they are used to decide whether borrowers (us everyday folk) are approved for credit cards, mortgages and other loans as well as determine the interest rate for those loans.
A credit score is an equation that uses variables to calculate an individual’s likelihood to repay debt (from the perspective of financial institutions). Modern credit scores were invented in 1956 by Bill Fair, an engineer, and Earl Isaac, a mathematician. The goal of the credit score was to provide an impartial system for determining the likelihood of a borrower repaying their debt. Rather than the system at the time which was individual lenders deciding whether to grant loans or not.
Understanding your credit score
While the credit score was made with the intention of impartiality, we can see today that all systems including mathematical equations have biases. When it comes to credit scores, the variables included in the equation are payment history (35%), credit utilization (30%), length of credit history (15%), new credit (10%) and credit mix (10%).
Your payment history is evaluated by your tendency to pay your bills in full and on time. This includes credit card and other loan payments as well as payments for utilities, cell phones and other billers. And we can acknowledge today that reflecting these variables on paper is heavily influenced by socioeconomic status.
Credit utilization
Credit utilization is what people tend to associate with good credit. Credit utilization is the amount of your total credit limit (across all lines of credit) in use. For example, if you have two credit cards each with a $2,000 limit and owe $1,000 on one and $750 on the other (wishful thinking, I know), your credit utilization ratio is $1,750 ÷ $4,000 = 43.75%.
You want to keep your credit utilization under 15% to boost your credit score. If your credit limit is small, you can reach out to your bank and ask them to increase your credit limit to keep yourself under 15%.
Length of credit history
Having a longer credit history positively impacts your credit history as it shows lenders evidence that you’ve made timely payments over time and are a reliable borrower. This is not one you have much control over since some people have had credit cards since they were young and others have not. If you don’t have a credit history or any credit cards, start as soon as possible.
New credit
Whenever you apply for a new line of credit such as a credit card, student loan or personal loan, lenders inquire to your credit report. Every time a lender inquires into your credit report, a few points are docked from your credit score.
Credit mix
Credit mix is the variety of types of credit you hold. Most commonly, we think of credit as our credit cards. Credit also includes different types of loans and lines of credit. Common types of loans include student loans, personal loans, auto loans, mortgage loans, etc. A line of credit is a preset borrowing limit that can be tapped into at any time. Lines of credit differ from traditional loans in that you only pay interest on the money you spend, not the total borrowing limit available to you. In theory, the more variety in types of loans you hold, the better your credit score. The caveat there is if you hold large student or personal loans, that impacts your credit utilization ratio which accounts for a larger percentage of your credit score.
Finding your credit score
Your bank will most likely have a report of your credit score for free in your online portal. Checking your free credit score does not affect your credit score because it isn’t a formal credit inquiry.
You can also get a free copy of your credit report at AnnualCreditReport.com. Usually, free access is limited to one copy per year. In light of the COVID-19 pandemic impacting credit scores, the Big Three credit reporting agencies (TransUnion, Equifax and Experian) are offering free weekly online credit reports through AnnualCreditReport.com.
Now that you know how credit scores work, read “Building credit in your 20s” to learn how to build a good credit score.
