What Are Credit Scores?

You likely already know that having a good credit score comes with major advantages: you may be able to access better loan terms, get discounts on insurance, and even unlock better opportunities for housing and employment.

But what are credit scores, exactly? Before you can start improving yours (or establishing one for the first time), you should understand the basics of credit scores and how they work. Let’s take a closer look.

What are credit scores?

If a friend asks you to borrow $100, you’d probably want to figure out whether they’re likely to pay you back or not. You might check with your other friends to see if they’ve lent money to this person and if they ever got it back.

Banks, credit card companies, and other lenders can’t just ask your friends whether you’re likely to repay a debt. That’s why credit scores exist.

But what are credit scores? Your credit score is a number meant to show lenders how likely you are to repay debt on time and in full. That number is the result of a complex calculation involving your history with credit, your payment behaviors, your credit utilization, and other factors.

How credit scores are calculated

What are credit scores determined by? Credit reports and credit scores are compiled and calculated by credit bureaus (also called credit reporting companies or consumer reporting agencies). There are three major credit bureaus in the United States:

• Experian
• Equifax
• TransUnion

These credit bureaus obtain information about your credit history from credit card companies, banks, and other lenders. Once the credit bureaus have the most up-to-date information, they use it to determine your credit score.

The different types of credit scores

Many people use the word “credit score” as if it refers to a single number. But confusingly enough, there are two separate scoring models: FICO and VantageScore. Although they both aim to show lenders how risky or safe you are to lend to, they each work a bit differently.

FICO

When it comes to credit score calculation, FICO is the industry leader. It’s used by about 90% of top lenders. If you’re applying for any kind of credit, chances are that the lender will be checking your FICO score.

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The FICO scoring model takes all of your credit data into account, but it assigns different weights to different aspects. Five key factors go into determining your FICO score:

• Payment History: 35%
• Credit Utilization: 30%
• Length of Credit History: 15%
• New Credit: 10%
• Credit Mix: 10%

If you’ve ever looked up your FICO score, you may have seen more than one number. That’s because FICO periodically updates its scoring model. Many lenders use either FICO 9 or FICO 8.

FICO also has specific algorithms for credit card lenders, auto lenders, and mortgage lenders. These specialized scores assess the risk you pose to specific types of lenders.

Notably, each of the three credit bureaus — Experian, Equifax, and TransUnion — runs its current data through the FICO model to calculate your score. It’s not unusual for your score to vary slightly depending on which credit bureau it came from.

VantageScore

VantageScore isn’t as popular as FICO, but over the last two decades, it’s been slowly gaining in popularity. Like your FICO score, your VantageScore is calculated using several weighted factors.

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VantageScore uses six factors to determine your credit score:

• Payment History: 40%
• Depth of Credit: 21%
• Credit Utilization: 20%
• Balances: 11%
• Recent Credit: 5%
• Available Credit: 3%

Because FICO and VantageScore assign different weights to credit factors, it’s possible to have one be significantly higher than the other.

For example, imagine you recently made a late payment on a credit card. The payment was 30 days late, so it was reported to the credit bureaus. With both the FICO and VantageScore models, your payment history is the top factor influencing your score. However, VantageScore gives it a 40% weight, and FICO gives it 35%.

This means that while your late payment will lower both of your credit scores, you’ll likely see a bigger drop in your VantageScore than you will in your FICO score.

What is a good credit score?

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You know that having good credit can benefit you in a number of different ways. But what is “good” credit, exactly?

Every credit score is on a spectrum. To help people understand where their credit stands, FICO and VantageScore publish score ranges.

FICO scores can be as low as 300 or as high as 850. These ranges can help you evaluate the strength of your credit score:

• Exceptional: 800+
• Very Good: 740-799
• Good: 670-739
• Fair: 580-669
• Poor: <580

Today, VantageScores range from 300 to 850, just like FICO scores. But that wasn’t always the case. Before the release of VantageScore 3.0 in 2013, VantageScore used a 501-990 range. 

This was confusing for obvious reasons. For instance, a FICO score of 750 would be considered very good, but a 750 VantageScore would just be considered average. 

VantageScores range from “poor” to “excellent.” Here are the current score ranges:

• Excellent: 748-850
• Very Good: 716-747
• Good: 661-715
• Fair: 600-660
• Poor: 300-599

Now that VantageScore and FICO use the same score range, consumers and lenders both have a much easier time evaluating overall creditworthiness. 

Why credit scores matter

What are credit scores used for, and why do they matter? It’s easy to dismiss your credit score as just a number. But the truth is that your credit score can impact many areas of your life. Here are some of the key reasons your credit score matters:

Good credit unlocks better loan terms

If you have poor credit, you may not be approved for loans and other types of credit. The higher your score, the more likely you are to be approved for lower interest rates and other favorable loan terms that could save you hundreds (or even thousands) of dollars over time.

Credit may impact your housing application

If you rent your home or are planning to rent in the future, it helps to have good credit. Many landlords will look at your credit score when assessing your application. If your score is too low, they might see you as too risky and rent to someone else instead.

You could save money on insurance

In some cases, companies that provide car insurance and homeowners’ insurance may take your credit score into consideration when setting your premiums. If you have good credit, you might pay less each month.

You may qualify for better credit cards

As your credit score improves, you might find that you start qualifying for credit cards with better perks. Cards that offer cash back, travel rewards, and other benefits often have higher credit score requirements.

You may have an easier time connecting utilities

If you move to a new home and have to set up utilities, having good credit is a plus. A utility company can’t deny your application based on bad credit, so to reduce their risk, they may require you to pay a deposit.

You may look good to potential employers

In some states, employers may review your credit report as part of the hiring process. They usually can’t see your exact score. However, if you have a poor credit score because of negative items on your credit report, potential employers may see you as unreliable.

What can hurt your credit score?

You might wonder: What are credit scores most affected by? The weighted factors that FICO and VantageScore use to create your credit score may offer some insight. But if you’re trying to work on your credit, it helps to know what real-world circumstances can cause your score to drop. Here are some common examples:

Late payments

Both FICO and VantageScore have your payment history as the most important factor when determining your credit score. Just one late payment can lead to a significant drop in your credit score.

It might seem as if forgetting to make a payment on time isn’t a very big deal. However, like most negative items on your credit report, late payments remain for seven years. Fortunately, the late payment’s impact on your credit score is likely to lessen over time.

High credit utilization

The cost of living seems to just keep going up, and more people are relying more heavily on credit cards. If you’re one of them, you might have recently seen a decline in your credit score.

That’s because high credit utilization (using a significant portion of your available credit) is seen as a red flag by lenders. Typically, lenders prefer to see you use no more than 30% of your available credit (and no more than 30% of each individual credit account). Using less than 10% is even better.

Having accounts go to collections

Unpaid debts don’t get sent to collections overnight. If a bill goes to collections, it’s likely already caused significant credit damage because you failed to pay on time. However, because having an account in collections is an even bigger red flag to lenders than having a late payment, you might see your score drop even further.

Surprisingly enough, the impact that a collection account has on your credit depends (at least in part) on your prior credit score. If your credit score was 700 before your bill went to collections, your score will suffer more damage than if it were 400 before.

That might seem counterintuitive. However, keep in mind that the main objective of the credit system is to show lenders how risky you may be to lend to. A person with a 700 score is fairly safe to lend to, but if they have an account go to collections, it’s a major increase in risk. Their score will drop to reflect that risk, and it’s entirely possible that it will be lowered by 100 points or more.

On the other hand, someone with a credit score of 400 is already a risky borrower. Having an account go to collections will probably reduce their score somewhat, but they don’t have as far to fall.

Declaring bankruptcy

Declaring bankruptcy is usually a last resort if you’re in major financial distress. Individual consumers will usually declare one of two types of bankruptcy:

• Chapter 7: Discharges most debts but may involve seizure or sale of your assets
• Chapter 13: Creates a structured repayment plan but lets you keep assets

Bankruptcy can help you achieve a financial clean slate, but it can cause major credit damage. It’s not unusual to see your score fall 100 to 200 points or even more.

Like late payments, bankruptcy stays on your credit report for a significant amount of time. Chapter 13 bankruptcy remains for seven years, and Chapter 7 bankruptcy remains for 10.

Closing old accounts

Imagine you’ve just paid off a credit card. You have a real sense of accomplishment, and because you’re determined not to rack up more debt, you decide to close the account.

It’s completely understandable to close a credit card to remove the temptation to use it again. However, you should be aware that doing this can lower your credit score. Why? It all goes back to credit utilization. 

Imagine you have two credit cards. One has a credit limit of $2,000 and a $1,000 balance. The other has a credit limit of $1,000 and a $0 balance. Your total available credit is $3,000, and you’re using $1,000, so your credit utilization is 30%.

Now imagine you close the $1,000 card. Your available credit is now just $2,000, and you still have $1,000. That means your credit utilization has jumped to 50%, even though you haven’t taken on any new debt.

Applying for a lot of credit at once

When you apply for a loan, credit card, or another type of credit, the lender does what’s called a “hard inquiry” into your credit file. This may cause your credit score to temporarily drop by a few points.

A single hard inquiry isn’t too damaging. However, if you apply for multiple credit lines at once, your credit score might drop substantially. Applying for multiple credit lines around the same time suggests to lenders that you’re desperate for credit and that you might fail to repay debts as agreed.

How to improve your credit score

Now that you know the answer to the question “What are credit scores?” you may have a clearer idea of why having good credit is so important. If your score isn't quite where you want it to be, don’t be discouraged. These steps might help you start moving your score in the right direction:

Check your credit report for errors

Credit reports are usually fairly accurate, but errors still can and do happen. If you want to improve your credit score, start by getting a copy of your credit report from all three bureaus. Look closely for any errors or accounts you don’t recognize.

If you do spot an error, you should reach out to the data furnisher (the company that reported the information to the credit bureau). You should also file a dispute with every credit bureau that included the error on your report. You should be able to do this online.

Keep making on-time payments

When you have a long history of making all payments as agreed, it makes you look responsible to lenders. If you currently have a car loan, a personal loan, a credit card, or any other type of credit account, just making on-time payments should help boost your score over time.

Paying down debt and keeping utilization low

High credit utilization is a common problem, and it can seriously bring your credit score down. If you have high credit card balances, make a plan to pay them off. These are two common strategies:

• Snowball Method: Pay the card with the lowest balance first
• Avalanche Method: Pay the card with the highest interest rate first

If you can qualify for a debt consolidation loan, you may be able to pay your debt off faster. These loans tend to have much lower interest rates than credit cards do.

Increasing your available credit can also help boost your score. If you have a family member or friend with great credit, you might consider asking them to add you as an authorized user.

Open a secured credit card

If you have poor credit or a thin credit file, you may have heard people recommend that you get a credit card, use it to pay for gas or groceries, and pay it off each month. That’s generally good advice. But what if you can't qualify for a traditional credit card?

This is the exact situation that secured credit cards were made for. With these cards, you start by paying the lender a refundable deposit. That deposit becomes your credit line. You make purchases and pay them off just as you would with a regular card. After a certain period of time, the lender returns your deposit. They may also upgrade the account to a traditional credit card.

Try a credit-builder app

There are many different strategies you can use to boost your credit score, and they tend to be more effective when you use them together. Keeping track of your strategies and your progress can be confusing, but a credit-builder app can help you stay on track.

Kikoff is one of those apps. When you sign up with us, you gain access to a small credit line you can use to make purchases in our store. You pay those purchases off over time, and we report your on-time payments to credit bureaus.

That’s not all we offer, though. Kikoff also has tools to help you budget, track your spending, and build savings. Members can access debt negotiation tools, secured credit cards, credit-builder loans, and other tools to help them build credit while moving toward financial wellness.

Ready to start building your credit?

What are credit scores, and why do they matter? Now that you have a clearer idea, you might be ready to start working toward improving your own score. Building credit can be a challenge, and it takes time. But when you have support, it gets a little easier.

Kikoff was designed to help people from all backgrounds improve their credit or establish it for the first time. Joining is free, and we don’t check your credit. Get started with us today!