What Is Credit Score?

Definition

Credit score is a statistical measure that evaluates an individual's or business's creditworthiness, developed by Bill Fair and Earl Isaac, who founded Fair, Isaac and Co. in 1956, and introduced the FICO credit score in 1989.

How It Works

The credit score is calculated based on information in an individual's credit report, which is maintained by credit bureaus such as Equifax, Experian, and TransUnion. The credit report contains details about an individual's credit history, including payment history, credit utilization, length of credit history, types of credit used, and new credit inquiries. FICO's credit scoring model, which is widely used by lenders, considers these factors and assigns a score between 300 and 850, with higher scores indicating better creditworthiness. According to FICO, the average credit score in the United States is around 710 (FICO), and lenders often use this score to determine the interest rate and terms of a loan.

The credit scoring process involves complex algorithms that weigh the different components of an individual's credit history. For example, payment history accounts for 35% of the FICO credit score, while credit utilization accounts for 30% (FICO). The scoring model also considers the length of credit history, with longer histories generally resulting in higher scores. The types of credit used, such as credit cards, mortgages, and installment loans, also factor into the score, with a diverse mix of credit types generally considered more favorable. New credit inquiries, which can indicate a higher risk of default, are also considered in the scoring model.

The credit scoring model is continually updated to reflect changes in consumer behavior and credit market conditions. For example, FICO's latest scoring model, FICO 9, incorporates rent payment history and other non-traditional credit data to provide a more comprehensive picture of an individual's creditworthiness (FICO). This update reflects the growing recognition of the importance of non-traditional credit data in evaluating credit risk.

Key Components

• Payment history: This component considers an individual's record of making on-time payments, with late payments and accounts sent to collections negatively affecting the score. A single late payment can decrease a credit score by up to 100 points (FICO).
• Credit utilization: This component considers the amount of credit being used relative to the available credit limit, with high utilization ratios negatively affecting the score. Credit utilization above 30% can decrease a credit score by up to 50 points (FICO).
• Length of credit history: This component considers the length of time an individual has been using credit, with longer histories generally resulting in higher scores. A credit history of 10 years or more can increase a credit score by up to 50 points (FICO).
• Types of credit used: This component considers the mix of credit types, such as credit cards, mortgages, and installment loans, with a diverse mix generally considered more favorable. A mix of 3-5 different credit types can increase a credit score by up to 20 points (FICO).
• New credit inquiries: This component considers the number of new credit inquiries, which can indicate a higher risk of default, with multiple inquiries in a short period negatively affecting the score. 5 or more inquiries in a 12-month period can decrease a credit score by up to 100 points (FICO).

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 (Experian).

Myth: Paying off debt will immediately improve credit scores — Fact: Paying off debt can take several months to reflect in credit scores, as credit bureaus update reports periodically (Equifax).

Myth: Credit scores are only used by lenders — Fact: Credit scores are also used by landlords, insurers, and employers to evaluate creditworthiness (TransUnion).

Myth: Credit scores are fixed and cannot be changed — Fact: Credit scores can be improved by maintaining good credit habits, such as making on-time payments and keeping credit utilization low (FICO).

In Practice

In the United States, credit scores are widely used by lenders to evaluate creditworthiness. 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 (Bank of America). In 2020, the average credit score for mortgage borrowers in the United States was 765 (CoreLogic), and lenders such as Wells Fargo and JPMorgan Chase use credit scores to determine the terms and interest rates of mortgages and other loans.