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

Ah, your credit score: a seemingly innocuous three-digit number that dictates your interest rates on virtually every loan you apply for — and whether or not you get approved to borrow money in the first place. 

On the positive side, having a Very Good or Excellent 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. 

But how exactly do credit scores work? What are “hard” and “soft” checks? Where do credit scores come from? And how can you improve your credit score as quickly and efficiently as possible? 

What is a credit score (and why do they exist)? 

Let’s start with the basics; what is a credit score, why do they even exist and who’s tracking all this stuff for us? 

Credit scores 101

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), the lender will almost always 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 Scores: 

• 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 credit accounts (e.g. credit card, auto loan, mortgage) and making essentially all of their 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. 

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 a business or entity requests a copy of your credit report from a credit bureau during an actual application process. Hard checks will make credit scores fall temporarily (usually by five points or less) and 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 a lender or other entity requests your credit report for informational purposes only 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. 

One of the main reasons we have separate hard and soft checks is to identify why people are looking at your credit report. If 30 personal loan companies looked at your credit report just so they could send you junk mail, that’s a totally different story than you applying for 30 personal loans. 

How does your credit score work? 

Your credit score works by taking your credit history and summarizing all of the good stuff (e.g. on-time payments) and the bad stuff (e.g. too many loan applications, bankruptcies) into a single, three-digit number. 

In other words, if your credit report is your report card, your credit score is your overall GPA. 

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 (e.g. mortgage, credit card), 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.

So how does FICO crunch all of this into a three-digit number? 

How credit scores are calculated 

FICO keeps the details of their secret recipe under wraps, but here’s what they have told us. 

Your credit score is a combination of five distinct factors, all weighted a little differently. 

Source: Experian

Here’s a brief breakdown of each individual slice of the pie and how it’s calculated: 

Payment history – 35%

Payment history is the big one, comprising more than a third of your overall FICO score. This category factors in things like your on-time payments, your late payments, how far behind you are on those payments, how many of your accounts are overdue, and whether or not you’ve declared bankruptcy before. 

Amounts owed – 30%

Amounts owed are the second biggest slice of the pie and mostly consist of your credit utilization ratios. This is the ratio between the balance of your revolving accounts (mostly your credit cards) and the limit of those accounts. 

To illustrate, 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 Experian says 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 that 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 are going to 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 it as a single hard inquiry. Note that credit card applications are not treated the same way, and each credit card application has its own hard inquiry.

Related: How to build credit over time

How can you improve your credit scores? 

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

We’ve written up a full feature on how to increase your credit score (the right way), but here’s a quick summary of the highlights: 

1. Check your credit report for errors

A 2013 study by the Federal Trade Commission (FTC) found that one in four consumers had an error on their credit report that might be impacting their overall credit score. That’s why it’s a good idea to 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 (in the right order)

Let’s say that you have three credit cards with varying balances and APRs. Which one do you pay off first to improve your credit the fastest? 

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

Related: What is the debt snowball?

4. Hold off on nonessential loan applications

As you work to improve your credit score, keep in mind that 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 refi or a balance transfer card), but it might be good to hold off on an auto loan or a personal loan you don’t need right away. 

5. Keep making on-time payments 

The best thing you can do to build credit is to make 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’s no shortage of tools and programs out there that can help you build your credit quickly. Balance transfer credit cards can help you consolidate credit card debt onto a single card with 0% APR. A secured credit card can help you get a foot in the door with credit by allowing you to put down a deposit as collateral for the credit account. Experian Boost can also help you get extra credit for paying all of your bills on time.

FAQs

Is 700 a good credit score? 

A score of 700 is considered Good (670 – 739). In 2022, the average FICO score in the U.S. was 714 according to Experian.

How does credit work when you first start out? 

When you apply for your very first loan, your credit score is neither 300 nor 850. It simply doesn’t exist and the lender has to take a chance with you. Then, based on how well you handle your first loan, you’ll typically land between 500 and 700 within the first three to six months. 

Who invented credit scores?

In the 1980s, the “Big Three” credit bureaus — Experian, Equifax, and TransUnion — began working with an analytics firm called Fair, Isaac, and Company, also known as FICO. Together, they launched the FICO score in 1989, which has become the industry standard credit score used by 9 out of 10 top lenders.

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