They are just three little numbers, but they play a huge role in determining whether or not a lender will lend you money. I'm talking about your credit score. That number not only helps lenders decide whether or not to approve a loan, and it also indicates what types of loans to offer. The score is created by a computer that scans through your credit reports, which contains information about your borrowing history.
To learn about your credit, it’s helpful to understand the big picture and then get into the details of specificcredit scores.
Credit Score Basics
Credit scores are designed to make lending decisions easier for lenders.
Banks and credit unions want to know whether or not you’re likely to default on your loan, so they look to your borrowing history for clues. For example, have you borrowed money before and successfully repaid loans, or have you recently stopped making payments on several loans?
In the past, lenders had to manually read through your credit reports, which include page after page of details about your borrowing history. When you get a loan, lenders report your activity to credit bureaus, and that information is compiled into credit reports. Reading through those reports is time-consuming, and it’s easy to miss important details.
With credit scores, a computer program reads that same information and spits out a score – a simple number that lenders can use to evaluate how likely you are to repay. Instead of spending 20 minutes on each loan applicant, scores take much less effort to generate.
Credit scores can also be beneficial to borrowers.
Lenders are less able to use subjective judgment when a score tells them most of what they need to know. Scores won’t (or shouldn’t) discriminate based on how you look or how you act.
Types of Scores
You have numerous credit scores. For every scoring model that’s been developed, you have at least one score.
Most people refer to the FICO credit score when talking about scores, but you have several different FICO scores – one for each credit bureau – plus other types of scores. When talking about your credit, it’s important to understand specifically what type of score is being used.
Traditionally, the FICO score is the most popular score used for important loans like home and auto loans. However, that’s gradually changing. No matter what score you use, most models are looking for more or less the same things: they want to predict if you’re likely to pay your bills on time.
The FICO credit score looks at how much debt you have, how you’ve repaid in the past, and more. Scores fall anywhere between 300 and 850 and are made up of the following components:
35% Payment History – have you missed payments or defaulted on loans?
30% Amounts Owed – how much do you owe (and are you maxed out)?
15% Length of Credit – is borrowing new to you?
10% New Credit – have you applied for numerous loans in the recent past?
10% Type of Credit – do you have a healthy mix of different types of debt (auto, home, credit cards, and others)?
Alternative credit scores are often based on similar information. But some people don’t have a history of borrowing – maybe you’re young, or you’ve just never borrowed.
Newer “alternative” credit scores look at other sources of information, such as whether or not you pay your bills on time (including utility bills, rent, and more).
Other types of scores also exist. They might use a combination of information from credit reports and other sources. For example, lenders sometimes build customized “application scores” that use information you supply in your loan application (your income or amount of time at your current residence might be used).
Information About your Scores
How can you find out what your credit score is, and what’s in your credit reports?
Free credit reports are available to all U.S. consumers under federal law. To get your report from the three major credit reporting agencies (TransUnion, Equifax, and Experian), visit AnnualCreditReport.com. Remember that your scores are based on the information in your credit reports.
If your credit reports look good, your scores will be high.
Free credit scores are harder to come by, but there are several ways to get free scores. Ask your lender for your score any time you apply for a loan, and see if your bank or credit card company provides free scores. Be wary of websites that market free information – some of them offer “unofficial” scores (which might be helpful) and others are scams.
Credit scores do not determine whether or not your loan request is approved. They are simply numbers generated from your credit report (or other credit scoring model). Your lender sets standards on which credit scores are acceptableand makes the final decision. If you choose to live a debt-free life, you won't have a credit history or high credit scores (but it still might be worth it).
To improve your credit scores, you have to show that you're a seasoned, responsible borrower who is likely to repay on time. If you build your credit files with positive information, your credit scores will follow. It takes time, but it is possible.
Sometimes your credit report contains errors. When this happens, you can miss out on opportunities that you otherwise deserve. It's essential that you get those errors corrected in case anybody is asking about your credit. The process is tedious but well worth your time. For time-sensitive fixes (when you’re applying for a mortgage and buying a house), rapid res-coring can get your scores higher within a few days.