How Creditors Decide to Give You Credit

What is a credit score?

A credit score is a number that tells creditors and lenders how much of a risk you are. It’s calculated using a set formula and based off the information contained in your credit report.

• A low credit score means you are a high risk for getting new credit. You’ve had trouble with credit in the past, so you might have trouble with new credit now.
• A high credit score means you are a low risk for getting new credit. You are likely to pay your debts on time, so creditors and lenders are more likely to approve you for new credit.

Who makes credit scores?

Credit scores are calculated by independent companies. The most popular score that’s used by 90% of lenders is FICO, which is created by a company called Fair Issac Company. They started creating credit scores for people in the 1970s.

But a FICO score isn’t your only credit score. There are other companies that calculate their own scores. Different lenders and creditors will use different scores at certain times.

However, they all do the same thing. They all tell creditors how much of a risk you are.

How credit scores work

Most credit scores follow the same basic formula that FICO created. Your FICO credit score ranges from 300-850.

Your score is calculated based on five factors. Each factor has a different “weight” for how much it affects your score.

Payment history – 35%

The biggest factor is payment history. This looks at if you always pay your bills on time. Missed payments—where you don’t make a payment within 30 days—can have a huge negative impact on your score.

In fact, one missed payment can drop a good credit score by 100 points!

Smart Money Tip: Always pay your bills on time

The best thing you can do for your credit score is to pay your bills on time every month. Some of the other factors you’ll learn about below just take time to improve.

But paying bills for credit cards and loans on time every month will have a positive impact on your score now.

Credit utilization – 30%

The next factor measures how much debt you have compared to the available credit you have. It’s calculated as a ratio known as a credit utilization ratio.

You divide your total credit card balances by your total available credit limit. Then you multiply by 100 to get a percentage.

For example, let’s say you have three credit cards and each one has a $500 credit limit. You have a balance of $100 on two cards and $400 on the last card.

Total credit card balance: $600

Total available credit limit: $1,500

Credit utilization: 40% (600 / 1500 x 100)

Anything above 30% credit utilization starts to be bad for your credit score.

Smart Money Tip: Keep debt paid to boost your score

A low credit utilization ratio is always better. That means keeping your credit card debt paid off is great for your credit score.

If you pay off your credit card balances every month, you will be rewarded with a much higher credit score.

Credit age – 15%

The next factor looks at how long you’ve used credit. The idea is that someone that’s had accounts open for a long time is experienced with credit.

This factor looks at how long you’ve had each of your accounts and then takes an average. This is known as your “credit age.”

New credit applications – 10%

The next factor sees how many new accounts you’ve opened recently. The idea here is that if you’ve opened a lot of new accounts recently, you may be more of a risk because you’re taking on too much new credit at once.

This factor uses the credit inquiries listed on your credit report. When you apply for new credit and authorize them to run a credit check, it creates a credit inquiry.

Each credit inquiry can decrease your credit score by a few points. Too many inquiries at once can cause a bigger drop in your score.

Credit inquiries stay on your credit report for two years, but only affect your credit score for six months to a year.

Credit mix – 10%

The final factor evaluates the types of credit you have. Creditors want to see that you have experience with a wide range of different types of credit.

So, this factor improves as you gradually get different types of credit. You don’t just want to have credit cards. Having a credit card, an auto loan, and a student loan would be a more diverse mix.