Credit Score 101: How Does Credit Work?

From buying a home or car to even just applying for an apartment, your credit score proves to be a significant part of everyday life, ensuring that you can make small and big purchases of all kinds. Credit can be confusing to navigate for many reasons, but understanding how credit works and what your credit score actually means can bring you peace of mind and help you from digging yourself into a financial hole. Wondering “how does credit work” and want to learn more about credit? Our comprehensive guide covers all you need to know below.

Chapter 1

What Is a Credit Score?

A credit score is a three-digit number ranging from 300 to 850, which signifies your “creditworthiness,” or your general ability to repay borrowed money. The higher the number, the better your credit, though some creditors will grade this credit based on a certain range. The exact ranges and standards can vary based on the creditor and the type of credit score.

Chapter 2

How is Credit Score Used?

A credit score can have a significant role in your finances. Essentially, lenders and financial institutions can use your credit score as a means of predicting your ability to pay back loans on time. A lender could be a bank, credit card company, and even a car dealership. A non-lender, most notably a landlord or property manager, can also perform a credit inquiry and make decisions based on it. For example, a property manager may require you to have a good credit score to sign a lease.


Higher credit scores give you more options and flexibility and greater access to credit products. A borrower with a score of 750 or above may qualify for 0 percent financing on cars, or they can apply for credit cards with a 0 percent introductory credit card interest rate.

That said, a low credit score does not immediately disqualify you from making purchases. However, you may have to put down a deposit or pay higher interest rates on an auto loan, for example. Continuing with the car example, your insurance payments might be higher as well. For a mortgage, a lending institution may require a co-signer or have a shorter repayment term.

Chapter 3

How Are Credit Scores Created?

Your credit starts almost as soon as you borrow money in any form. Whether you apply for a credit card, take out a student loan or business loan, the information and data go directly to the three major credit bureaus in the United States (Equifax, Experian, and Transunion). These three credit bureaus store and report all of this information to calculate your credit score. As you apply for more loans, open credit accounts, and borrow money throughout your life, the credit bureau will update your credit score.

What Impacts Score?

This section will cover which of the following factors most impact your credit score. Five main factors impact your credit score.

Payment History

Accounting for up to 35 percent of your credit score

This the most significant factor, accounting for up to 35 percent of your credit score. This is what shows your ability to pay loans on time and includes:

The number of accounts that you have paid on time

The accounts that you are at least 30 days behind on with payments

Any instances of bankruptcy, past-due account collections or falling behind on a personal loan or line of credit at least 30 days

The number of days you are past due on a deliquent account

The amount past due for deliquent accounts and accounts sent to collections

Total Amount Owed

Your total amount owed to lenders accounts for up to 30 percent of your credit score. This amount shows the sustainability of your spending and can predict potential financial problems later on.

The factor includes:

HOW MUCH YOU OWE ON ALL YOUR CREDIT CARDS AND LOANS

THE NUMBER OF ACCOUNTS YOU CARRY ANY BALANCE ON

YOUR CREDIT UTILIZATION RATIO

Credit utilization ratio refers to the amount of credit you use to the total amount of credit you have. Generally, the lower the number on these factors, the better your score.

Length of Your Credit History

Essentially, having a long history of good credit makes for more accurate and predictable borrowing compared to a few months of fair to middling credit. Keep in mind that creditors usually use your open accounts’ average age or the age of your oldest open account, not the age of your first-ever account.

Types of Credit Accounts

This shows that you have a diverse mix of accounts and how recently you used them. Having credit cards, personal loans, mortgages, car loans, and student loans shows a more well-rounded borrowing history than having just a handful of credit card accounts.

New Credit

New credit factors into about 10 percent of your score, which refers to the number of new accounts you have applied for or opened recently. While there’s nothing inherently wrong with opening a new line of credit, opening or applying for too many accounts at once can show that you are desperate for more credit, which is usually a red flag.

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Chapter 4

Types of Credit Scores

Now that there is an understanding of what a credit score is and how it is created and used, financially responsible individuals need to know the different types of credit scores being evaluated today. There are currently two main types of credit scores:

The Fair Isaac Corporation, also known as FICO, introduced the credit score model over 25 years ago and is presently the industry leader for credit scoring within the United States. The score was the first of its kind that financial institutions and other lenders could utilize to gain insight regarding the people they would potentially lend and distribute their funds to.

FICO is the most recognizable credit scoring brand

Today, FICO is the most recognizable credit scoring brand, enough that the average financial institution uses “FICO score” and “credit score” interchangeably. 

In reality, your FICO score is just one type of credit. The company uses its own proprietary formula to calculate your credit. General FICO guidelines show:

Scores of 800 or above are considered exceptional credit.

Scores from 740 to 799 are considered very good credit.

scores between 670 and 739 are considered good  credit.

score between 580 and 669 are considered fair credit.

anything lower than 580 is considered poor credit.

FICO scores are reportedly used for at least 90 percent of lending decisions. They are favored exclusively for home mortgages through Fannie Mae, Freddie Mac, and other government-sponsored home lending entities. If you are having trouble with your score, here are some tips on how to increase your FICO score.

Although FICO scores are the predominant favorite in the world of credit scores, VantageScore, another credit reporting agency, is gradually gaining traction among lenders and consumers. It is seen as favorable because the three national credit bureaus created it: Equifax, Experian, and TransUnion.

A goal of VantageScore is to expand the number of people who can receive credit scores

A goal of VantageScore is to expand the number of people who can receive credit scores, for example, college students and immigrants, and other individuals who might not use credit frequently. 

While both still use the same factors listed above, they use different analytics and unique algorithms to determine your credit score. While previous versions had ranges of 501 to 990, the current VantageScore model uses the same 300 to 850 range as FICO with some small differences.

A VantageScore of 781 to 850 is considered excellent.

A score of 661 to 780 is a good score.

Credit ranging from 661 to 660 is considered fair.

A score from 500 to 600 is poor.

A score of 300 to 499 is considered very poor.

New Credit Scoring Versions

It is also important to note that both FICO and VantageScore have released new credit scoring versions due to evolving lender credit-granting requirements, overall demand for credit, and consumer credit use. Currently, the most used FICO version is FICO® Score 8. There are several unique features included in FICO® Score 8 such as high credit card usage, isolated late payments, authorized user credit, and more.


Vantage’s newest version is VantageScore 4.0, which uses machine learning and incorporates trended credit data newly available from all three credit bureaus. Ultimately, both FICO and VantageScore’s versions help lenders make more informed and fair decisions.

Chapter 5

How is Credit Reported?

A credit report displays a summary of your credit accounts, including your payment history and other information reported to credit bureaus from lenders and financial institutions. Credit reports come from the three credit bureaus in the country, and your reports from each may not be the same.


Potential creditors and lenders can request a credit report to decide whether to provide you with a loan or extend your credit line. Utility companies can also check your credit report for insurance reasons.

Credit Scores vs. Credit Reports

While credit scores and credit reports are intrinsically linked, they are not the same or interchangeable. Your credit score is a single number denoting your creditworthiness.


Credit reports are much more comprehensive, showing:

 

your personal information

Details on each of your accounts

Any inquiry information, including both soft and hard inquiries

Unfavorable information (bankruptcies, repossessions, past-due collections)

Think of your credit report as an in-depth look at your credit, while your score is a simple summation of all your credit.

Think of your credit report as an in-depth look at your credit, while your score is a simple summation of all your credit. Lenders will often look at both to make their decisions.

Chapter 6

How to Improve Your Credit Score

New to Credit

If you are new to credit, you may be wondering how to build your credit score. You may be surprised to find that improving your credit score is relatively easy. Start with a simple credit card. Use the card normally, but make sure not to exceed 30 percent of the total to ensure a good credit utilization ratio. Above all, make sure that you pay your credit card on time.


Another approach to increasing your credit score is by applying for and successfully paying off a credit building loan. These particular types of loans are designed entirely to build your credit score, allowing you to be a more financially stable and reliable individual in the eyes of a banking institution or lender.

How does this all work? Just follow these simple steps:

1) Apply for a Possible credit building loan

2) Repay your Possible loan on-time

3) Possible reports your payments to Experian and TransUnion

4) Watch your credit score increase!

Borrow a quick loan and when you repay the loan, you build your credit history.

On traditional credit-building loans, the money you pay your lender goes into a savings account. At the end of the loan term, you receive the money you put in, and the lender reports your previous payments to the credit bureaus. Other credit building loans, like here at Possible, allow you to borrow a quick loan and when you repay the loan, you build your credit history. These loans have very competitive APRs, and if you are struggling to pay off one of our loans, you can extend your payment up to 29 days with no fees.

Starting from Bad Credit

Start by paying off your bills, existing loans, and credit card debit.

A bad credit score can be discouraging, but it’s not impossible to raise that score. Start by paying off your bills, existing loans, and credit card debit. This tactic gives you a clean slate while also gradually helping to improve your credit.

From there, you can consider a credit building loan mentioned above or start a secured credit card. Possible considers all individuals’ financial situations, offering credit building loans to people who may appear to have poor credit or a shorter credit history. A secured credit card requires a refundable security deposit. The issuing entity holds the security deposit as collateral until you close the account, which reduces the risk for banks and credit unions.

Starting from Good Credit

Consider applying for a credit limit increase.

If you already have good credit, keep it up. Consider applying for a credit limit increase, which can help to lower your credit utilization ratio and improve your credit score. Avoid closing any credit cards.

Even if you don’t use it, closing a credit card essentially removes that credit amount, lowering your overall credit card utilization and may contribute to a lower score.

Avoid closing any credit cards

Understanding how credit scores work can be tricky initially, but much of it comes down to common sense. Pay your bills on time, don’t max out credit cards, and maintain healthy credit habits.

Sources

Chang Fu

Chang is an avid writer, among other things, at Possible. He grew up loving reading and writing, creating his own poems and even a book he's now hidden in an old closet, unpublished. His financial experience at a large bank along with his passion for technology to help underserved communities inspires him to write for Possible.