Example of Credit Score

Credit score is a three-digit number that represents an individual's or business's creditworthiness, developed by Fair Isaac Corporation (FICO) in 1989.

Definition

Credit score refers to a numerical value that lenders use to assess the creditworthiness of borrowers, with higher scores indicating lower credit risk.

How It Works

The credit score calculation involves several factors, including payment history, credit utilization, length of credit history, credit mix, and new credit inquiries, with FICO's model being the most widely used. Payment history accounts for 35% of the total score, with on-time payments contributing positively and late payments negatively affecting the score. Credit utilization, which accounts for 30% of the score, is calculated by dividing the total amount of credit used by the total amount of credit available, with a lower utilization ratio resulting in a higher score.

The credit score calculation also considers the length of credit history, which accounts for 15% of the score, with longer credit histories generally resulting in higher scores. Credit mix, which accounts for 10% of the score, refers to the variety of credit types used, such as credit cards, loans, and mortgages, with a diverse mix of credit types contributing positively to the score. New credit inquiries, which account for 10% of the score, refer to the number of new credit applications made by the borrower, with excessive inquiries potentially negatively affecting the score.

Credit scores are used by lenders to determine the likelihood of repayment and to set interest rates, with higher scores resulting in lower interest rates and more favorable loan terms. For example, a borrower with a credit score of 750 or higher may qualify for a mortgage interest rate of 3.5% or lower, while a borrower with a credit score of 650 or lower may be offered an interest rate of 5% or higher.

Key Components

• Payment history: on-time payments contribute positively to the score, while late payments negatively affect it, with Experian reporting that 61% of lenders consider payment history when evaluating creditworthiness.
• Credit utilization: a lower utilization ratio results in a higher score, with Equifax recommending a utilization ratio of 30% or lower to maintain a healthy credit score.
• Length of credit history: longer credit histories generally result in higher scores, with TransUnion reporting that borrowers with credit histories of 10 years or more tend to have higher credit scores.
• Credit mix: a diverse mix of credit types contributes positively to the score, with FICO's model considering the presence of different credit types, such as credit cards, loans, and mortgages.
• New credit inquiries: excessive inquiries may negatively affect the score, with Credit Karma reporting that borrowers who apply for multiple credit cards or loans in a short period may experience a decrease in their credit score.

Common Misconceptions

Myth: Checking credit reports will lower credit scores — Fact: Checking credit reports is considered a soft inquiry and does not affect credit scores, as stated by Experian.

Myth: Credit scores are only used for loan applications — Fact: Credit scores are used for a variety of purposes, including credit card applications, apartment rentals, and employment screenings, with FICO's model being used by 90% of lenders.

Myth: Credit scores are fixed and cannot be improved — Fact: Credit scores can be improved by maintaining a good payment history, reducing credit utilization, and avoiding excessive new credit inquiries, with Credit Karma reporting that borrowers who improve their credit scores can qualify for lower interest rates and more favorable loan terms.

Myth: Credit scores are only applicable to individuals — Fact: Businesses also have credit scores, which are used to evaluate their creditworthiness and determine loan terms, with Dun & Bradstreet providing business credit scores.

In Practice

In the United States, the average credit score is around 716, according to Experian. A borrower with a credit score of 750 or higher may qualify for a mortgage interest rate of 3.5% or lower, while a borrower with a credit score of 650 or lower may be offered an interest rate of 5% or higher. For example, a borrower with a credit score of 780 and a $200,000 mortgage may qualify for an interest rate of 3.25% and a monthly payment of $870, while a borrower with a credit score of 620 and the same mortgage amount may be offered an interest rate of 5.5% and a monthly payment of $1,130.