- A credit score is meant to predict the risk that someone will default on a loan in the next two years.
- A credit score determines the types of credit an applicant would be eligible for.
What is a credit score?
A credit score is a number that is meant to capture the likelihood a consumer will pay back all of their debts over the next two years.
But here’s the thing: lenders know they can’t predict what will happen with any one individual. So, they use a person’s credit score to predict how much credit a lender can offer weighed against the risk of the debt not being repaid (i.e. default).
Is a credit score trying to predict my future?
No, it’s impossible to predict the future. But a credit score helps lenders understand your situation relative to other potential borrowers.
How is my credit score calculated?
Unfortunately, there isn’t a simple way for someone to calculate their own credit score; however, all of the factors that make up your score are known. Good credit scores are built with a history of good credit usage. If you don’t use credit, you won’t have a credit score.
Credit scores are the product of a complicated algorithm that attempts to account for the incredibly diverse experiences of over 200 million Americans. Credit scores, such as FICO Score and VantageScore, are created from hundreds of different pieces of information that are recorded in a credit report. Through a mix of sophisticated analysis and modeling, credit scoring companies distill down all this complexity into a three-digit number.
How a credit score calculation works is a closely guarded secret, but we do know the important factors such as payment history, the percent of the credit limit being used (i.e. utilization), and how long the accounts have been open.
It’s a simple number that helps us all understand a very complicated financial picture.
Why do lenders use credit scores?
There are two reasons that lenders use credit scores. The first is to help the lender determine to whom they can responsibly offer a loan. The second is to help to remove inadvertent bias from their lending decisions to make credit access more equitable for all.
What are the different types of credit scores?
The most common “types” of credit scores are really named after the credit score companies who created them, FICO and VantageScore. These two companies have created multiple credit score algorithms over time, each of which is designed to predict the likelihood that consumers will repay their debts. There are also credit scores developed by other scoring companies and even individual lenders, but they all have the same purpose.
What are the ranges for credit scores?
The most common credit scores have a range between 300 and 850. FICO also has specialty credit scores for both auto loans and credit cards that provide additional insight for lenders, which range from 250 to 900. It may be impossible to have a perfect score, and more importantly, it’s unnecessary. The score is relevant only insofar as it gives you access to the credit you need at a cost you want.
What does a credit score actually mean?
Your credit score is not a determination of your future or a judgment of integrity or character. It’s simply meant to show how likely you are to repay all of your debts over the next two years.
An individual’s credit score is relative to other scores. A higher score suggests a higher likelihood of successfully keeping current on loan obligations compared with someone with a lower score. FICO and VantageScore develop their scores to help lenders determine whether to extend credit to an applicant and how much to charge.
The following table gives approximate credit scores needed to qualify for various lending products:
What you can do:
Credit Scoring 101