How Do Credit Scores Work (and Why Do They Matter)?

Your credit score may seem like an innocuous number, but it dictates your interest rates on virtually every loan you apply for — and whether you get approved to borrow money in the first place. 

On the positive side, having a good credit score can help you save on your student loans, score a top-tier rewards credit card, and even help you afford a better home one day. 

What Is a Credit Score (And Why Do They Exist)?

Your credit score is a three-digit number that tells the world how reliable you are with borrowed money.

When you apply for a loan (e.g., mortgage, credit card, car loan), the lender will look at your credit score to determine if they’re willing to lend you money and what loan terms they can offer you. 

There are multiple types of credit scores, but the most popular among lenders is the FICO score, which ranges from 300 to 850.

You may have also heard the terms “excellent” or “fair” applied to credit scores. These aren’t general descriptors, but official terms to describe ranges of scores.

Here are the ranges for FICO: 

• Excellent: 800 – 850
• Very Good: 740 – 799
• Good: 670 – 739
• Fair: 580 – 669
• Poor: 300 – 579

Generally speaking, someone with excellent or very good credit will have years of experience taking out a variety of loans and making payments on time. 

By contrast, someone with fair or poor credit might have missed a few payments, maxed out a credit card, applied for too many loans at once, and/or filed for bankruptcy. 

You can check your own credit score through a free service like Credit Sesame or Credit Karma.

Your bank or financial institution likely also offers a way for you to check your score through their app. Or you could go straight to the credit bureaus — Equifax, Experian, and TransUnion all offer free credit checks and reports.

Who’s looking at your credit score (and why)? 

These days, it’s not just potential lenders looking at your credit. All of the following groups might have a look at some point: 

• Mortgage lenders
• Credit card companies
• Student loan servicers
• Landlords
• Employers
• Government agencies
• Insurance companies
• Utility providers

There are various reasons why non-lenders will want a look at both your credit report and your score.

A landlord, for example, may want to see if you have unpaid debt that might impact your ability to pay rent. An employer — especially one in finance — may want a general sense of how well you handle money. 

What are “hard” and “soft” inquiries? 

“Hard” and “soft” represent the two ways that companies can check your credit report and score: 

• A hard inquiry, also known as a hard pull or hard check, occurs when someone requests a copy of your credit report from a credit bureau. Hard checks will make your score dip temporarily (usually by five points or less). In 99% of cases, the requester needs your written permission before making one.

• A soft inquiry, known as a soft pull or soft check, occurs when someone requests your credit report for informational purposes that aren’t tied to a loan or other application. Soft checks do not affect your credit score and don’t require your permission to make. 

What is a credit report (and what shows up on it)? 

Your credit report is a detailed account of you and your money-borrowing history.

Here’s everything that appears on it: 

• Personal information, including your name, nickname, birthday, Social Security number, current and former addresses, and your phone number(s)
• Info on each of your accounts, including the type, the credit limit, current balance, payment history, date of opening and closing, the name of the lender/creditor, and whether the account has been sent to collections
• Public records, including any liens, foreclosures, bankruptcies, civil suits, or judgments with your name on them
• Credit inquiries include a list of all hard and soft pulls going back several years. 

Interestingly, lenders aren’t actually required by law to report your borrowing behavior to the national credit reporting agencies (Experian, Equifax, and TransUnion). In fact, they actually have to pay the credit bureaus to report on you. However, the vast majority still choose to as an incentive for consumers to pay on time.

READ MORE: How To Check Your Credit Score for Free

How Credit Scores Are Calculated 

FICO keeps the details of their secret recipe under wraps, but we know that credit scores are a combination of five distinct factors, all weighted a little differently.

Payment history – 35%

This category factors in things like:

• Your on-time payments
• Your late payments and how far behind you are on them
• How many of your accounts are overdue
• Whether you’ve declared bankruptcy before

Amounts owed – 30%

Amounts owed mostly consist of your credit utilization ratios. This is the ratio between how much you've borrowed and how much credit you have available.

Let’s say you have a credit card with a balance of $3,000 and a total credit limit of $6,000. Your credit utilization ratio for that account is 50%.

That may not sound like much, but it’s best to keep your credit utilization ratio below 30% across all accounts. 

Credit history – 15%

Credit history shows lenders how long you’ve been effectively managing loans.

It looks at the age of your newest account, the age of your oldest account, and the average age of your accounts. 

Credit mix – 10%

Your credit mix is a measurement of how many different types of loans you’ve taken out.

If you have a mortgage, a credit card, an auto loan, and student loans, you have a pretty healthy and diverse mix of revolving credit and installment credit.

Lenders like to see that because it shows you have experience managing multiple loans and lines of credit.  

New credit – 10%

Last but not least, your new credit is where all of your hard inquiries live. If you have a 790 credit score but apply for 17 different loans this week, future lenders want to see this eyebrow-raising behavior reflected in your credit score. 

That said, if you apply for five or six car loans at once just to see who has the best rates, you won’t get dinged every time. FICO realizes that rate-shopping is totally normal behavior and that consumers shouldn’t be punished for doing their due diligence.

So, as long as you make all loan applications of the same type within 45 days, FICO treats them as a single hard inquiry.

But note that credit card applications are not treated the same way. Each credit card application has its own hard inquiry.

RELATED: How To Build Credit From Scratch

How Can You Improve Your Credit Score? 

Now that you know what goes into a credit score, what are some of the fastest and easiest ways to improve it? 

1. Check your credit report for errors

Start with a deep dive into your credit history to look for anything fishy, such as revolving credit that you never opened.

You can get a free credit report using the FTC-approved website AnnualCreditReport.com. 

2. Find the issues and clean up past-due accounts

Even if your credit report has no errors, it may still have some issues dragging down your score.

Thankfully, modern credit reports do a good job of pointing out exactly where the problems are so that you can begin addressing them in the right order.

Most of the time, it’s a combination of past-due accounts and missed payments. 

3. Pay down balances

Your amounts owing make up one of the biggest factors affecting your credit score, so pay those down as soon as possible.

Most experts recommend what’s known as the “debt avalanche” method, which involves paying off the debt with the highest interest rate first, regardless of the outstanding balance.

This can prevent high interest from spiraling out of control, help you avoid missed payments, and lower your overall credit utilization ratio. 

READ MORE: Why It’s Hard to Get Out of Debt With Only Minimum Payments

4. Hold off on nonessential loan applications

Most new credit or loan applications will involve a hard inquiry that will ding your score by a few points.

That doesn’t mean you should avoid taking out a loan that will help you consolidate debt or save money (such as a student loan refinance or a balance transfer card), but hold off on a personal loan you don’t need right away. 

5. Keep making on-time payments 

Most credit card companies, lenders, commercial landlords, and even utility companies will report your on-time payments to the credit bureaus, which collectively can pump up your score pretty quickly.

If you can, set as many of your accounts on autopay as possible — there’s nothing more forehead-slapping than realizing you missed a payment when you had the money. 

6. Try some credit-building tools

There are plenty of tools and programs out there that can help you build your credit quickly.

If you don't yet qualify for a credit card, a secured credit card can help you get a foot in the door by allowing you to put down a deposit as collateral for the credit account. You can then start to build your credit profile through responsible use.

Services like Experian Boost, RentReporters, and Bilt Rewards can help you get extra credit for paying your rent and other bills on time.

FAQs

TL;DR: Credit Scores 101

Your credit score is essentially your financial report card that tells lenders, landlords, employers, and even insurance companies how trustworthy you are with money.

It's calculated using five key factors: your payment history, how much you owe, how long you've had credit, your mix of different loan types, and recent credit applications.

The higher your score, the better rates and terms you'll get on everything from credit cards to mortgages.

The good news? You have more control over it than you might think. Focus on the big two factors that make up most of your score: Pay every bill on time (even if it's just the minimum) and keep your credit card balances low.