Credit Scores 101

Your credit score is a number that signifies your creditworthiness. It is derived from the information in your credit report; think of it as your credit report's grade. A low number means you have bad credit, while a high number denotes good credit.

If you've had problems in the past with paying back debts, you may have a low credit score. Conversely, if you have a history of paying back debts promptly, your credit score will be high. The higher the score, the lower the risk you appear to lenders and credit card companies. They will be more likely to offer you lower interest rates and better terms than someone with a low credit score.

A Good Credit Score Saves You Money

When applying for loans and lines of credit, it's important to put your best foot forward. Know what shape your credit is in and take steps to improve it before going to lenders. It could end up saving you hundreds of dollars each month, and thousands in the long run.    

For example, say John has a credit score of 770 and goes to apply for a home mortgage. Because of his excellent credit score, he is likely to get the best interest rate available in today's economy. The mortgage lender offers him 6% on a $200,000 mortgage, making his monthly payments $1,195. On the other hand, Mary, who has a score of 650, will only qualify for a 7.7% interest rate for a mortgage of the same amount. She'll be paying $1,435 each month, or $240 more than John. Ultimately, her loan will cost her $86,374 more than John’s will cost him.

History

The Fair Isaac Corporation began developing credit (or FICO) score models in the 1950s. Before credit scoring, financial institutions made lending decisions the old-fashioned way—that is, by manually reviewing each applicant's complete financial situation and meeting with them in-person to discuss their assets, income, and character.

Now, all major lending institutions use some form of credit scoring to evaluate applicants. Judging people based on a number is much quicker and more efficient than a manual review by an underwriter.

Multiple Scores

FICO is just one brand of a credit score formula. Each bureau has its own formula to derive credit scores. All of these are based on the original FICO scoring system and weigh similar factors like payment history, but to varying degrees. Most formulas are based on a range of approximately 300 to 850.

Another caveat is that lenders may or may not use the bureau scores as they come. An institution will often formulate its own score for you based on industry-specific factors. For example, a mortgage lender likely uses a different scoring model than a credit card company.  So it's highly likely that the financial institution is evaluating you using a different score than what you obtained from the bureaus.