What Do Lenders Use for Credit Scores?

Imagine walking into a bank to apply for a loan, filled with confidence, only to be told that your credit score disqualifies you. This is an all-too-common scenario, and the mystery around credit scores can be incredibly frustrating. Most people only think about their credit score when it’s too late—after they’ve been denied a loan or had to settle for higher interest rates.

So, what exactly do lenders look for when assessing your credit score? And more importantly, what do they use to calculate it? In today's financial world, credit scores are not just numbers; they are critical decision-making tools that determine your financial opportunities. But understanding what drives your score is the first step to improving it and gaining more control over your financial future.

Lenders rely on credit scoring models like FICO (Fair Isaac Corporation) and VantageScore, the two most commonly used systems, to assess the risk of lending you money. These models look at a variety of factors, but they prioritize five key components: payment history, amounts owed, length of credit history, new credit, and types of credit used. Each of these has a different impact on your overall score.

The Importance of Payment History

Payment history is the most significant factor in determining your credit score, accounting for about 35% of your total score. Simply put, lenders want to know if you pay your bills on time. Late payments, bankruptcies, and delinquencies are red flags. If you have a history of late payments, it can drastically lower your score and make it harder for lenders to trust you.

On the flip side, consistently paying bills on time builds a positive track record, which boosts your score over time. For example, if you've never missed a credit card payment in the last three years, lenders will view you as less of a risk, and you’re more likely to be approved for loans or get better interest rates.

Debt Utilization Ratio

Next up is your debt utilization ratio, which refers to how much credit you’re using compared to how much is available to you. This makes up 30% of your score. Lenders want to see that you're not maxing out your credit cards, and they prefer borrowers to use less than 30% of their available credit. For example, if you have a credit limit of $10,000 and you’re using $3,000, that’s a 30% utilization rate, which is ideal. Higher utilization rates signal to lenders that you may be relying too heavily on credit, which could lead to default.

Interestingly, paying off your credit cards every month can help lower your utilization ratio and positively impact your score. Many people mistakenly think that keeping a small balance on their cards is beneficial, but in reality, zeroing out your balance each month is the best strategy.

The Length of Your Credit History

The length of your credit history plays a smaller but still important role, contributing to 15% of your score. Lenders like to see that you’ve been using credit responsibly over a long period. The longer your credit history, the more information lenders have about your financial behavior.

For example, someone who has had a credit card for 10 years, with consistent on-time payments, is generally seen as less of a risk than someone who just opened their first credit account last year. However, this doesn’t mean that new borrowers are automatically penalized—lenders will still look at how responsibly you manage your accounts during the time you’ve had them.

New Credit Applications

New credit accounts for 10% of your score. Whenever you apply for new credit, whether it's a credit card, mortgage, or personal loan, the lender performs a "hard inquiry" into your credit history. While a single hard inquiry can slightly reduce your score, multiple inquiries in a short period can have a larger impact, as it might suggest you're in financial trouble or desperate for credit.

That said, credit inquiries within a specific window—typically 14 to 45 days—are usually treated as one inquiry when you’re rate shopping for things like a car loan or mortgage, so your score isn’t negatively affected by seeking the best deal.

Types of Credit

Finally, the types of credit you use make up the last 10% of your credit score. Lenders like to see that you can manage different types of credit, such as credit cards, mortgages, and auto loans. Having a mix of revolving credit (credit cards) and installment loans (like a mortgage or car loan) shows that you can handle different types of debt responsibly.

However, don't go out and apply for a bunch of new credit just to improve your credit mix. Instead, focus on using the credit you already have responsibly.

Why Your Credit Score Matters

So, why does all of this matter? Your credit score can open or close doors in your financial life. A good credit score can mean access to lower interest rates, better loan terms, and even opportunities for renting apartments or getting a job. On the flip side, a poor score can limit your options and make everything more expensive—from loans to insurance premiums.

For instance, someone with a credit score of 750 could qualify for a mortgage with an interest rate of 3.5%, while someone with a score of 600 might only qualify for a rate of 5.5%. Over the life of a 30-year mortgage, that difference in interest rates could cost tens of thousands of dollars more in interest payments.

How to Improve Your Credit Score

Now that you know what lenders look for in your credit score, you can take steps to improve it. Here are some strategies:

• Pay your bills on time: Set up automatic payments or reminders to avoid missing due dates.
• Keep your credit utilization low: Aim to use less than 30% of your available credit.
• Avoid applying for new credit too often: Only apply for credit when you need it, and be mindful of how many inquiries you have.
• Maintain a good credit mix: While it’s not necessary to have every type of credit, having a good balance between revolving and installment credit can help.
• Review your credit report regularly: Mistakes happen, and they can negatively affect your score. You're entitled to a free credit report every year from each of the three major credit bureaus—Experian, Equifax, and TransUnion.

By following these steps, you’ll not only improve your credit score but also enhance your financial health and increase your opportunities for better loans and financial products.

In the end, understanding what lenders use to calculate your credit score gives you the power to take control of your financial future. The key is to be proactive, stay informed, and manage your credit responsibly.

The best time to start improving your credit score? Right now.