What is a credit score and why do we need them?

Every time you apply for any type of credit the creditor must ask, “What are the chances that this individual will pay back his or her debt, with interest, in a timely manner?” A credit score helps the creditor answer these questions by indicating whether or not you are a good credit risk.

A credit score is a numerical value that reflects your credit worthiness. It is a figure obtained through statistical analysis of your credit report information, which is typically obtained from a credit reporting agency (also known as a credit bureau). The three major credit reporting agencies are Equifax (800-685-1111), Experian (888-397-3742 and Trans Union (800-888-4213).

Creditors use a statistical program to compare a number of different variables from your credit report, for example, your payment history, types of open credit and outstanding debt, to the repayment history of individuals who share a similar payment profile. Points are assigned to each factor that helps predict whether or not someone will repay their debt.

You are perceived to be a low risk if you have a high credit score. Under these conditions, you will be granted the best loan conditions. This means you will likely be rewarded with a low interest rate (a low annual percentage rate), which allows you to pay less interest on the borrowed money than someone who has a low credit score. There are several types of scoring systems. For example, the three major credit reporting agencies introduced VantageScore in 2006 which has a range of 501-990. However, the most well-known and commonly used scoring system is the FICO score. Ranging from 300 to 850, the higher the number, the better the score.

Information from your credit report is distributed into five major categories that make up your FICO score. Some are weighted more heavily than others.

  • 35% Payment History – Since 35% of your score is obtained from your payment history, it is extremely important to pay your bills on time.
  • 30% Amount Owed – Balances on all of your credit cards and installment loans, compared to the total available credit limits on all of your cards accounts for 30% of your score. It’s called a “debt-to-credit-limit ratio” and it should be kept as low as possible. Less than 30% is optimal; more than 50% is way too high.
  • 15% Length of credit history – The length of your credit history makes up 15% of your score. The longer you display good credit habits, the higher the score.
  • 10% New Credit – The number of recently opened accounts and credit inquiries establishes 10% of your score. It’s frowned upon to have too many cards (more than 3 or 4) or to seek lots of credit in a limited period of time. The last 10% of your score comes from the mix of credit held.
  • 10% Mix of Credit – Higher scores go to those who show they can manage a credit card or two along with an installment loan such as a car or student loan.

As stated above, it is standard procedure in the United States for a creditor to check your credit score before advancing you money for such things as a car loan, mortgage, credit card or personal loan. Creditors want to know if you’re a good risk; someone who is responsible, who repays their debts in a timely manner.

It is also now common for insurance companies and phone companies to review your credit score before granting you service. For example, using your credit score and other factors, an insurance company may try to predict whether or not you will file an insurance claim as well as the amount of the claim. The results of this analysis can determine the premium you will be charged.