How Does a Credit Score Work?

You may not monitor your credit score every days part of keeping track of your personal finances, but as soon as you need a big loan, it suddenly becomes all too important. A lender pulls your credit report before agreeing to loan money to you. The ​three​ major credit reporting agencies use a credit scoring model called FICO, which is a reflection of your credit history, current credit utilization and the types of credit you have.

Your credit score is a ​three-digit​ number that represents the risk you pose to a lender considering loaning you money. Think of it like a report card issued by the credit monitoring agencies that grades your behaviors when it comes to managing your money. This ​three-digit​ score is called a FICO score.

Your FICO score is made up of the following:

• Payment history (​35 percent​)
• Total a mount currently owed (​30 percent​)
• Length of credit history (​15 percent​)
• New credit (​10 percent​)
• Mix of credit (​10 percent​)

​Read More:​ Credit Score for Mortgage Rates: How It Works

Credit reporting agencies don’t monitor your activity directly. Your creditors report your activity to the ​three​ major credit bureaus, which are Equifax, TransUnion, and Experian. If you file bankruptcy or an account goes to collections, the credit bureaus are typically notified, at which point they record the information.

While paying bills on time is essential to protecting your score, those on-time payments won’t always boost your score. For example, your credit card company or local utility provider might not report your activity to credit bureaus unless it’s negative. Even if a creditor reports positive activity, it might only be to ​one​ bureau, not all ​three​. Creditors aren’t required to report activity at all.

Each lender has different requirements when considering whether to loan someone money. But while that minimum can vary, generally speaking, most creditors look for someone with an exceptional, very good or good credit score. Here are the FICO credit score ranges:

• Poor: ​300-579​
• Fair: ​580-669​
• Good: ​670-739​
• Very Good: ​740-799​
• Exceptional: ​800-850​

FICO isn’t the only game in town, though. A competitor to FICO is VantageScore, which has a little more flexibility in the lower ranges than FICO. VantageScore has the following ranges:

• Very Poor: ​300-499​
• Poor: ​500-600​
• Fair: ​601-660​
• Good: ​661-780​
• Exceptional: ​781-850​

​Read More:​ Is a 672 FICO Credit Score Good or Bad?

If you’ve never taken a loan or had a credit card, you can have a tough time when you apply for new credit. Your credit history shows lenders your creditworthiness, based on whether you’ve paid your bills on time each month for an extended period. Without that history, you can be seen as a credit risk simply because there’s not enough information to indicate otherwise.

The Consumer Financial Protection Bureau estimates that about ​45 million​ consumers may be credit invisibles, which simply means they don’t have enough of a credit history to qualify for a score. Since payment history makes up the vast majority of your FICO score, it’s essential to work to build a credit score. This can be as easy as making a small purchase on a credit card and paying it off on time each month until you start to establish a history of payment.

As a lender looks at the types of credit, ​one​ area jumps out: new credit. In fact, new credit makes up ​10 percent​ of your FICO score. Any application for new accounts remains on your report for ​two years​, although your FICO score only includes inquiries that were initiated within the past ​12 months​.

There’s nothing wrong with shopping around for new credit. But as you’re getting quotes and checking interest rates, pay close attention to the types of credit inquiries a lender offers and opt for credit card issuers with a soft credit pull rather than a hard one. A soft check doesn’t register with the credit bureaus, but hard inquiries do.

If you’re worried about the credit limits on your various credit card accounts and loans, it’s important to note that FICO doesn’t factor those into the equation. However, your credit limits do factor into your “amounts owed,” which accounts for ​30 percent​ of your credit score. Your credit card balances are calculated as part of your credit utilization, which is just the percentage of your available credit that you’re currently using.

To see if your credit utilization might be contributing to a bad credit score, first look at the outstanding balance on each of your loans or credit cards. Dividing that balance by the limit will give you your credit utilization ratio. If you have a $20,000 credit limit on a card with a $5,000 balance, your utilization ratio would be 25 percent.

Another contributor to your score range is the credit mix. It makes up ​10 percent​ of your FICO score, and it refers to the various types of accounts you have. Variety is best here. Lenders want to see that you have a history of responsibly handling various types of credit, from car loans to student loans to credit cards.

Here are the ​two​ major types of credit accounts that factor into your FICO score:

• ​Installment accounts:​ With an installment account, you pay back a loan in fixed monthly payments. Installment accounts include mortgages, student loans and auto loans.

• ​Revolving accounts:​ A revolving account doesn’t have a fixed monthly payment. You usually have a minimum amount due, but that can vary based on the current balance. Revolving accounts include credit cards and home equity lines of credit.

As you’re learning how credit scores work, you’ll probably read a lot about the importance of paying your bills on time. While this is important, it’s unlikely that missing a bill deadline by a few days will hurt you. In fact, late payment reporting typically doesn’t even happen until a payment is ​30 days​ late.

Even if you go beyond that ​30 days​ every now and then, it won’t necessarily hurt your score. Not all creditors report a late payment, and even if one does, if you have excellent credit overall, it likely won’t hit your score that hard. But that only highlights the importance of making sure you pay on time in case you have a slipup along the way.

​Read More:​ How Quickly Do Banks Report Late Mortgage Payments to Credit Bureaus?

If you miss a payment, even by a few days, it’s important to get in touch with the creditor as soon as possible. You may be able to not only avoid a report to collections but late fees, as well. Some creditors list a grace period of ​15 days​ or so before you’re charged a late fee, but that doesn’t necessarily mean your late payment won’t be reported to credit bureaus.

There might be times in life when you find you simply can’t pay your bills. If that happens, the best thing you can do is reach out to creditors and let them know the situation. Some creditors allow you to skip ​one​ or more payments in exchange for extending the life of the installment loan, or you may simply be able to negotiate a lower payment until your situation improves.

There’s no exact answer on how a bankruptcy will affect your credit. Generally speaking, though, those who have excellent or very good credit will see a bigger impact than someone who already has bad credit. Your score can also be more negatively affected as the number of accounts in the bankruptcy filing increases.

The biggest factor to consider before filing, though, is how long it will stay on your credit report. If you file a ​Chapter 13​ bankruptcy, which just has you setting up a repayment plan, it will only stay on your credit for ​seven years​. ​Chapters 7​ and ​11​, which discharge your debts so that you don’t have to pay them, will show on your report for ​10 years​.

Like other negative types of credit activity, collections can drop your credit score. It’s important to note that even if you pay the debt off as soon as the collections company contacts you, the information can still remain on your report for ​seven years​. When an account is sent to collections, a new entry is made on the credit report, which is listed as a collections account.

In addition to the delinquent payments that sent the bill to collections, a collections account serves as a negative item on your payment history. Since payment history is the largest factor in your credit score, it can keep a score down for a while. The collections account automatically comes off your report after ​seven years​, but if you see an erroneous collections account on your credit report, you can file a dispute to have it removed.

It’s important to pull your credit report occasionally and take a look at it. You're entitled to ​one​ free credit report each year through AnnualCreditReport.com. You can also get your copy by calling ​1-877-322-8228​. There are other services, like myfico, that charge a fee to monitor your credit scoring for a fee, on an ongoing basis.

Once you have your report, look it over carefully. Here are some things to look for:

• Review your personal information. Make sure your address, phone number and Social Security number are accurate. Incorrect information could be a sign of fraud on your account.

• Check all accounts listed as belonging to you. If you see a creditor you don’t recognize, research the company. It could simply be that a parent company is listed.

• Look at account statuses. Make sure there aren’t any closed accounts marked as open.

• Check for inaccurate payment history reports. If you see one that’s marked as late, highlight it and check your own records to make sure it was actually late. Your bank account should show when the payment cleared, and that can serve as proof it was paid on time.

• Verify credit limits and balances. Check your own records and make sure those are accurate since incorrect listings could alter your credit utilization ratio.

• Note all inquiries. This is a great way to spot fraud. You can see on your credit report a listing of all companies running hard inquiries that impact your credit score.

• Review any bankruptcies and foreclosures. Make sure no legal actions are listed on your report that you weren’t involved in.

Incorrect reports taint your credit history and can reduce your credit score. But there’s good news. All three credit bureaus have a process in place that allows you to dispute errors on your report.

To file a credit report dispute, go to the website for the credit bureau and look for the File a Dispute link. There will be a form to fill out. The bureau will either correct the error or reach out to the creditor to verify the information that was reported. If the company doesn’t respond within a specified timeframe, the reporting agency will correct the error.

It might seem that paying off all your debts is the best way to boost your credit score, but that isn’t always the case. The first step to take if you want to improve that score is to request a copy of your credit report and dispute any errors. Then work hard to pay bills on time to keep your score high and make sure your report stays as clean as possible.

If you have at least ​one​ credit card and the means to do so, start charging at least some of your monthly purchases. Give yourself bonus points if you get rewards for spending using your card. Make sure you pay off the entire balance every month, not just the minimum, and try to keep your credit utilization ratio as low as possible before you pay it off.

Understanding how credit scores work is an important first step in strengthening your score and keeping it high. Some financial institutions let you monitor your score, so take advantage of that perk. Also, make sure you regularly check your credit report and clear up any errors on it. With time and diligence, you’ll eventually have your score exactly where you want it to be.