With how much credit scores affect our daily lives, it’s hard to believe that it was only a short time ago that the average consumer didn’t even know that credit scores existed. Credit scores came into being in the 1980s. Before that, lenders had to use their own judgment to determine who they should lend money to. It wasn’t until the 1990s that people began to realize what credit scores were, and even then, lenders were not allowed to tell borrowers what their credit scores were. Consumers brought up the valid point that if they didn’t know what was on their credit report how did they know if they were being judged fairly and accurately? This led to new legislation being passed in 2000 that allows consumers to view their own credit scores.
Credit scores range from 300-850 and are meant to determine how likely you are to be late on a payment at any time in the next year. A credit score between 300 and 499 is considered bad. 500-579 is poor, 580-619 is low, 620-679 is average, 680-699 is good, and 700-850 is excellent.
The 3 major credit bureaus in the U.S. (TransUnion, Experian and Equifax) use the Fair Isaac model of credit scoring to calculate credit scores. The credit bureaus amass data regarding a consumer’s lending habits, calculate a score based on this data, and report that score to lenders when that consumer applies for a loan, utilities, cell phone contract, jobs, etc.
Different aspects of your lending and spending habits affect your credit score in different ways. Each aspect is given a weighted impact on your final score. A basic model of weight is as follows:
- 35% is how you pay your bills. Whether or not you pay on time and how many days delinquent you have been are the main factors.
- 30% is the amount of money you owe compared to the amount of credit you have available. Using only around 30% of your available credit at any given time is good; using only 10% is ideal.
- 15% is the length of credit history. The longer running your accounts are (when they’re in good standing), the better your score will be.
- 10% is having mixed credit. Lenders like to see that you can manage different types of debt successfully. The best credit scores will be made up of both revolving accounts (like credit cards) and installment loans (like car loans).
- 10% is new credit applications. Coupling recent late payments and defaults with shopping for new credit raises a red flag to lenders and lowers your credit score.
Credit scores aren’t perfect and they rely on accuracy of spending and lending information to produce a score. Now that consumers have access to their credit scores, they are able to monitor them and make sure the information is correct and true. Understanding how your credit score works can help you better manage it and better position yourself for loans and mortgages in the future.