Love them or hate them, good or bad, your credit scores are going to wield considerable influence over you for the rest of your life. You cannot change the fact that others are going to use your credit scores to judge you. However, you can use that knowledge to your advantage. It’s certainly in your best interest to learn how credit scoring works and, more importantly, to learn how you can earn and maintain the best credit scores possible.
The Purpose of Credit Scores
Credit scores exist primarily to help lenders, insurance providers, and many other types of companies to maximize their profits by reducing their risk. To achieve the goal of maximizing profits, lenders and other companies need to be able to understand the risk of doing business with you. Your credit scores provide lenders and others with an easy-to-use number that makes the risk prediction process consistent and simple.
Both VantageScore and FICO credit scores are designed to predict the likelihood that a consumer will become 90 days late or worse on any credit obligation within the next 24 months. This is known as the “Performance Definition” or “Stated Design Objective” of a credit bureau risk score.
If a scoring model determines (by reviewing the information on your credit reports) that your risk of making a 90+ late payment within the next 24 months is high, then your credit scores will be low. Conversely, if the risk level is low, then your credit scores will be high.
- Related: What’s a Good Credit Score?
How Credit Scores Are Built
You may find it hard to believe, but you have hundreds of different credit scores. While that can be confusing for consumers, the good news is that all of these credit scores are based on the same information – the data contained in your three credit reports.
All credit scoring models are designed using a series of “scorecards.” A scorecard analyzes the information on your credit report and then calculates a score based on that information. Each credit scoring model typically has multiple scorecards designed to evaluate risk for a unique or homogeneous group of consumers.
For example, a scoring model might have separate scorecards designed to evaluate consumers with a bankruptcy, consumers with clean credit reports, and consumers with thin files (i.e., not much information on their reports). Scorecards designed for groups with elevated risk, such as bankruptcy, will typically feature more restrictive treatment of the credit report data.
Once your report has been assigned to the appropriate scorecard, the information on your credit report will be evaluated and points assigned. The scorecard will ask questions of your credit reports and the answer to those questions will determine how many points you earn.
Here is a hypothetical example:
| Scorecard | Clean credit report |
| Question | How many inquires appear on credit report in the past 12 months? |
| Answers & Points | 0 Inquiries = 55 Points 1-2 Inquiries = 45 Points 3-4 Inquiries = 35 Points 5-6 Inquiries = 25 Points 7+ Inquiries = 0 Points |
The number of points you earn for each question and answer will be added together, and the total number will be the credit score you’ve earned.
As you can see, you don’t actually “lose” credit score points based on the information on your credit reports. Instead, if a negative item appears on your credit report, you will simply earn fewer points than you might have earned otherwise.
Related Articles:
- What Your Credit Score Is Trying to Tell You
- How Often Does Your Credit Score Change?
- Five Things People With Good Credit Have in Common
The post Here’s How Credit Scoring Actually Works appeared first on The Simple Dollar.
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