How Do Credit Scores Work, Anyway?

In the United States, basically every part of our financial life revolves around something called a credit score. We all know what a credit score is, but not many of us know how those work. Prospective borrowers tell lenders a lot about themselves with just three-digits, those being your credit score. Lenders will know if you normally pay your bills and loans on time or if you are in the habit of paying late. They will also know what types of recorded debt you have including car loans, mortgages, and even what percentage of your credit card borrowing capacity is available to you each month.

The FICO credit scoring system hasn’t always been around, though. In 1841, the Mercantile Agency collected information from its members around the country to standardize the character and assets of the borrower. In the end, it was found that these statistics that were being collected were too subjective as many views had racial, class, and gender biases. 

Just over 100 years later, in 1956, the Fair, Isaac and Company – now known as FICO – was founded. They didn’t get their big break until 1989 when their algorithm became the industry standard for determining credit riskiness. 

When you apply for loans or new credit cards, lenders will rely on your credit history report to determine how risky of a borrower you are. You may not qualify for a car loan or mortgage if your credit score is too low, but if you do qualify with a low credit score, your interest rate will be much higher than those with excellent credit scores. This increased interest rate means a higher cost of borrowing the money. The reason for the lender increasing the interest rate is because you would be considered a higher risk borrower. 

What are some factors that impact your credit score?

  • Payment history – do you have a history of paying on-time consistently?
  • Percentage of credit usage – the more you use, the more your credit score will suffer.
  • Age of credit history – how long have you been a trustworthy buyer?
  • Mix of credit – how many forms of credit have you taken out? If you have more types, it’s positive towards your credit score.
  • Hard inquiries – if a lender looks at your credit score, it can negatively impact your credit score temporarily. 

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