Credit Scores: What Are They? How Do They Work?

Credit scores assist lenders to decide whether to approve loan applications or not and determine what credit terms are offered. Scores are generated by algorithms that use information from your credit reports that summarize your credit history.

Fundamentals of Credit Score

Credit scores are developed to assist lenders to make decisions. Banks and credit unions want to know the risk of your loan defaulting, so they look for clues about your credit history. They want to know, for example, whether you have borrowed money and successfully repaid loans, or whether you have recently stopped payments on multiple loans.

Instead of scouring the credit reports for each applicant for 20 minutes, looking at a score gives lenders a quick and general idea of the applicant's credit rating.

Borrowers can also be beneficial. Lenders are less able to use their subjective judgment when a score tells them most of what they need to know. Scores should not differentiate based on how you look or how you behave.

Types of Scores

You have multiple credit scores. For each scoring pattern that has been developed, you have at least one score. When you're talking about your credit, it's important to understand exactly what kind of score is used.

Traditionally, the FICO score is the most popular score used for important loans such as home and car loans. Regardless of what score you use, most models are searching for a way to predict how likely you are to pay your bills on time.

The FICO credit score shows how much debt you have, how you have repaid in the past, and much more. Scores range from 300 to 850 and are composed of the following components:

How To Determine Your Credit Score?

• Payment History: 35%. Have you missed payments or defaulted on loans?
• Current debt: 30%. How much do you owe and are you using credit cards?
• Credit Term: 15%. Is a loan new to you, or do you have a long history of borrowing and repayment?
• New credit: 10%. Have you applied for many loans in the recent past?
• Loan types: 10%. Do you have a healthy mix of different types of debt: car, house, credit cards, and others?

Some people have no credit history because they are young, have never taken out a loan or owned a credit card, or for other reasons. For these types of credit applicants, alternative credit scores look for other sources of information for payment histories, such as utility bills, rents, and more.

Impact on Credit

How much credit scores are affected by certain activities within the five categories that make up your score is difficult to measure. Credit reference agencies do not disclose such details, and even if they did, the algorithm is so complex with so many combinations of factors that it would be difficult to determine a single credit score for payment or missing payment.

Payment history and current debts together account for almost two-thirds of your score, so it is particularly important to do well in these areas. Credit reporting agencies keep records of late payments for seven years and also keep an eye on the percentage of missed payments. Also, the age of late payments plays a role. Thus, a person who has made 95 percent of their payments could actually be penalized less than someone else who has made 98 percent of his payments on time. This may be the case if the first person is late in payment every five to seven years, while the second person is late in payment every one to two years.

Ideally, you want to make 100% of your payments on time, but if you are late, you want to make sure that it is an isolated event so that you can move it to the past. The more time passes without further late payments, the more your score will improve.

Getting Approval

Credit scores alone do not determine whether your credit application is approved or not. They are numbers generated from your credit report and a tool for creditors to use. They set levels for which credit scores are sustainable and make the final decision.

To improve your Credit score, you need to show that you are an experienced, responsible borrower who is likely to repay on time. If you create your credit files with positive information, your Credit score will follow. It takes time, but it is possible.