Decoding your credit: how does a credit score really work?

The world of credit scores can appear complex, with its own set of rules and numbers that seem to hold some mysterious power over your financial life. 

In fact, the power is yours. Unraveling credit scores doesn't require superhuman abilities. It doesn’t even require a lot of money. Only a willingness to learn and follow some basic guidance. 

Managing your credit is an attainable skill that can empower you on your financial journey. Let’s look at exactly how credit scores work—and how you can make yours work for you.

What's in your credit score?

Your credit score is a three-digit number that measures how you manage debt. Credit scores are based on your credit reports, collections of information about your experience with credit. There are three main companies that collect this information (Equifax, Experian, and TransUnion), and each creates its own version of your credit profile.

FICO® scores are the credit scores the majority of lenders use when you apply for loans or credit cards. (You might also see a VantageScore® occasionally.) 

There are five factors that affect your FICO credit scores:

• Payment history

• How much of your credit limits you use (your credit utilization)

• The age of your credit accounts

• The types of credit you use (such as personal loans and credit cards)

• How often you apply for new credit 

VantageScores are based on similar information, but calculated in a different way.

FICO scores and VantageScores range from 300 to 850. Higher scores indicate lower risk. That means a high score could make it easier to get approved for credit and get the most favorable terms. 

Tip: Your employment history, income, bank account balances, marital status, race, religion, age, and gender don't impact your credit score. 

How to kickstart a credit score

To have a credit score, you need to have a credit report. To get a credit report, you need to have a credit account in your name. When you don't have enough credit history to generate a credit score, it's called a "thin" credit file. 

You might try any of these ways to establish credit if you're starting from scratch:

• Secured credit card. A secured credit card is a credit card that requires a cash deposit to open. After you use the card responsibly for a period of time (usually 6-12 months), you can transition to a traditional credit card and ask for your deposit back. Some credit card issuers will do this automatically. Secured credit cards can help you build credit over time if you make on-time payments and avoid maxing out the card.

• Credit builder loan. A credit builder loan helps you build credit by making on-time payments. But instead of giving you the loan funds upfront, the lender puts the money in a secure account. You make payments—which are reported to the credit bureaus—and once the loan is paid off, the lender turns the funds over to you. 

• Retail store card. Retail store cards are credit cards you can use at a specific store or family of stores. They usually have low credit limits and high interest rates, but they are sometimes easier to qualify for when you're building credit. And high interest may not matter if you pay off your balance in full every month, which is a great habit to establish.

• Authorized user. Becoming an authorized user means asking someone else to add you to their credit card account. You have spending privileges on the card (whether you actually ever use it or not), but you're not responsible for the debt. The primary cardholder's account history gets added to your credit report (you’d want to confirm with the card issuer that they report authorized users, but most do). If you do make purchases on someone else’s account, pay for your charges if that’s what you promised to do.

The common thread is that you have to show that you're making payments toward a debt (or that you're authorized to use the credit card of someone who is). Of the five credit score factors mentioned earlier, payment history is the most important. 

Tip: If you're a student, you could apply for a student credit card, or get a student loan in your name. Either one could help you build credit, as long as you make payments on time. 

How do you find out your credit score?

Check out these options for checking your ‌credit scores for free. If you arrive on a payment screen, click away and start over. 

• Your bank or credit union might offer free credit scores.

• Your credit card issuer might offer free credit scores.

• Some major national banks offer free credit scores to anyone, even if you aren’t a customer.

• Many free credit score websites offer free scores (usually VantageScores) and tips for improvement.

• If you apply for credit, ask the lender if they are willing to share your credit report and credit score.

What can you do to improve your credit score?

If you've checked your credit score and it's not where you'd like it to be, you've got the power to change it. How you improve your credit depends on what's dragging your score down the most. 

To change your credit quickly…

• Focus on credit utilization. After payment history, the second most important factor in credit scoring is credit utilization. Utilization is your credit card balance compared to your credit limit. It’s calculated for each card and overall. If you have a credit card with a $500 limit and your balance is $490, your utilization is 98%. Maxed-out cards (or nearly maxed out) are bad for your credit profile. Bringing the balance down is likely to help your score. As a backdoor method for improving utilization, you could ask your credit card company for a credit limit increase. Just don’t increase your balance.

To change your credit over time…

• Pay on time. It’s not possible to over-stress the importance of on-time payments. Even one late or missed payment can do serious damage to your credit score. Paying on time, every time, is a proven way to raise your score.

• Keep older accounts open. While it's not as important as other credit scoring factors, your credit age (how old your credit accounts are) does matter. If you have older credit card accounts you're thinking of closing, you might be better off leaving them open. Use them once in a while (and pay them off) to maintain your positive account history. 

• Think carefully about applying for new credit. Taking out an installment loan and opening credit card accounts can help your credit mix, which is another scoring factor. But applying for new credit usually causes your score to temporarily drop by a few points. Also, a new account will lower your average credit age. It's better to apply for new credit only when you really need it. Credit mix tends to happen naturally over time anyway as your financial needs change.

Tip: A soft credit inquiry is when someone views your report, but you aren’t applying. If you check your own credit, that’s also a soft inquiry. Soft inquiries don’t affect your score at all. Hard inquiries happen when a lender pulls your credit report as part of an application, and they can affect your score.

Credit score myths 

There's a lot of misinformation surrounding credit reports. Here are some of the most common myths. 

• Myth: Closing a credit card account can help your credit score.

Fact: Closing a credit card could lower your score if it increases your credit utilization ratio or lowers your account age.

• Myth: You have just one credit score.

Fact: While FICO is the gold standard for credit scoring, there's more than one kind of credit score. It’s normal to have multiple credit scores.

• Myth: Credit bureaus assign you a "good" or "bad" credit rating.

Fact: Credit bureaus create credit reports based on your credit activity, but they don't mark your score as "good" or "bad.”

• Myth: Couples have a joint credit report.

Fact: Everyone has their own credit report, regardless of relationship status. It's possible for a credit account to show up on two people’s credit reports if they're co-borrowers or co-signers on the account. 

• Myth: Checking your credit hurts your credit score.

Fact: Checking your own credit won't affect your credit in any way. It's a good thing to do to better understand what's helping (or hurting) your scores. 

• Myth: Your credit score reflects your intelligence or worth. 

Fact: Credit scores are a snapshot, based on reported data, that tells lenders how much of a financial risk someone might be. They can’t explain why your credit profile is the way it is, or what you’ll do with your finances next week. Smart people have credit scores all over the map. You're much more than your credit score—no matter how low or high it is.

Credit score mistakes to avoid

To protect your credit score, it’s best to avoid actions that might cause your score to go down—unless you’ve decided that the action will help you accomplish your goals. For instance, applying for a new loan can cause your score to drop by a few points, but your score can recover naturally over time. So don’t apply unless you really do need the thing you’re applying for.

Likewise, avoid paying your bills late or maxing out credit cards whenever possible. Those are the two things that can torpedo your score the fastest. 

There are more subtle mistakes to know about, too.

For example, co-signing a loan for someone can get you into trouble if they don't pay it off. As a co-signer, you're legally responsible for the debt. Payment activity—including late or missed payments—can show up on your credit reports. 

Another mistake is not using credit at all. You might think that by avoiding credit cards or loans, you can avoid debt, and avoid a bad score. And you're right about the debt part, and you won’t have a bad score. What you’ll have is no score. With no score, some lenders might turn you away. Instead of avoiding credit altogether, you're better off learning how it works and how to use it responsibly. 

Finally, don’t make the mistake of thinking that you have to carry debt to have a good score. You don’t. You can have a great score even if you pay off your credit cards every month.

When is your credit score important (or not)

Your credit score isn’t the be-all, end-all. In much of life, it doesn’t matter. 

Your scores are important if you are going to apply for a loan, borrow money, or rent an apartment soon.

It’s less important to focus on your credit score if you are already buried in debt or falling behind on your monthly minimum payments. In that case, focus on getting your debt under control. Once you do that, your credit score can naturally improve over time.

What's next

• Get copies of your credit reports, available for free through AnnualCreditReport.com.

• Check your credit score, if you haven't. You might be able to get your score for free through your bank, credit union, or credit card company. Or check a free credit score website or Experian.

• Look at the factors that are affecting your score. The site providing your score might break down those details for you automatically.

• Focus on changes to improve those areas that might be harming your score.