How Credit Scores Work

A good credit score can make your financial life a lot easier. It can save you money when renting an apartment, buying a car or getting a mortgage for your first home.

When you apply for credit, your prospective lender assesses the risk you pose as a borrower. Risk assessment is important to lenders because it helps them determine whether applicants are likely to pay them back as agreed. One of the tools lenders use in their decisions is a credit score. A credit score is a three-digit number based entirely and exclusively on the information found on your credit reports. When you have a higher credit score, lenders view you as a less risky borrower. Conversely, lower credit scores indicate elevated credit risk.

What exactly is a credit score?

According to the Fair Credit Reporting Act, a credit score is a numerical value derived from a modeling system used to predict the likelihood of default. Credit scores are used to differentiate higher-risk borrowers from lower-risk ones. To do this, the main consumer credit scoring models such as FICO and VantageScore, rank consumers using a 300-to-850 score range. These scores are important because they help lenders determine whether to lend you money and at what cost. If you have high credit scores, you will have better access to competitively priced credit from mainstream lenders. If you have low credit scores, your options will be more limited and more expensive.

How are scores calculated?

The different brands of credit scores actually have many things in common. Most credit scores consider information from your credit reports that reflect your payment history, debt, the age and diversity of your credit reports, and credit inquiries. While varying scoring models weigh the information slightly differently, your scores should never be wildly different if they are calculated from the same credit report at the same or similar points in time.

The most effective way to ensure that you’ll have good credit scores is by paying your bills on time and maintaining low amounts of debt, specifically credit card debt. If you apply for credit only when you truly need to, your credit reports will not be filled up with an excessive number of credit inquiries. Finally, scores tend to climb as the length of your credit history grows. If you perform well in all of these credit scoring categories, then you will likely have high credit scores.

What’s considered a good score?

The question of what is considered a “good” credit score is really best answered by your specific lender. Although lenders determine what is considered a good credit score, there is general consensus on the kinds of scores that indicate a responsible borrower.

As of mid-2020, the average FICO Score  was 707, while the average VantageScore credit score was 686. As such, anything at or around 700 is about an average score. Lenders, however, are looking for considerably higher scores if they’re going to approve credit applications with their best interest rates and terms. According to Informa Research Service, the lowest average interest rates on a 30-year fixed-rate mortgage are reserved for consumers who have FICO Scores of 760 or higher. The lowest average rates for a loan on a new car go to consumers who have FICO scores of 720 or higher.

Will checking your credit reports affect your credit scores?

It’s always a good idea to monitor your credit reports and credit scores regularly, especially since you can get so much of your credit information for free. Checking your own credit reports will not have any negative impact on your credit scores, as long as you’re accessing your credit reports from the right places.

Here at South Bay Credit Union, we encourage our members to check their credit score using SavvyMoney. SavvyMoney is a credit reporting and monitoring service where you receive free ongoing access to your credit score and credit report. You will also be able to better understand your credit score, factors that impact it, and what you can do to strengthen it. Plus, you’ll have custom recommendations to improve it along with personalized offers.

Checking your credit using SavvyMoney or other reputable methods will result in what’s called a “soft” credit inquiry being placed on your credit reports. Soft credit inquiries do not affect your credit scores.

How to improve your credit scores

Because your credit scores are a product of the information on your credit reports, for you to improve your scores you will need to first improve your credit reports. Some consumers have poor scores because of negative information on their credit reports, such as late payments, defaults or collections. For those consumers, the journey to higher credit scores will take longer because that type of negative information can remain on your reports for up to seven years.

The best way to improve your credit scores going forward, whether or not you have negative information on your credit reports, is to make all your debt payments on time—every time. Once the negative information in your credit reports starts to age and is eventually removed, your scores will improve.

If your credit scores aren’t as high as you’d like because of excessive credit card debt, then the news is more optimistic. As soon as you are able to pay down or pay off credit card debt, your scores will likely improve because of the reduction in the highly influential credit utilization ratio, which considers your credit card balances relative to your credit card limits.

“Most people strive to reach a better credit score, and it’s certainly possible if you do so carefully. Improving your score can prove rewarding in various ways, as a good credit score is extremely important”, said Bernice White, South Bay Credit Union, CLO.

The bottom line is, credit scores are used by almost all lenders for almost all credit-related products, and are certainly central to the decisions made by mortgage, credit card and auto lenders. Scores are used billions of times every year and continue to be a common tool for lenders during the application process. Not only is it a good idea to check your credit reports and credit scores often, but it’s also in your best financial interest to improve your credit reports so your credit scores will benefit.