What Is a Credit Score?

By Markets Fool.com

Your credit score is basically your Money GPA. It's a three-digit number that measures how you've handled money that you've borrowed.

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The score is based on your credit history, which is contained in your credit reports (or files) kept by the three major credit reporting bureaus -- Equifax, Experian, and TransUnion.

(Tip: Go to annualcreditreport.com to access your government-mandated free credit reports from each bureau.)

What Is It Used For?
When a lender requests your credit score, it's basically looking for an answer to the question: How much can I trust this person to pay me back? Then they'll determine if they want to do business with you, and on what terms -- how much money they'll loan you, and what interest rate they'll charge.

Credit scores factor into everything related to your finances -- from getting a credit card, buying a home or car, calculating your insurance premiums, and sometimes even whether or not you're hired for a job.

Who's Calculating My Credit Score?
Two main companies provide credit scores for industry and consumer use:

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  • Fair Isaac Corp.'s FICO score is by far the most popular credit-scoring system. It is used in more than 90% of lending decisions.
  • VantageScore is the credit rating product that the three major credit bureaus created via a joint venture in order to compete with FICO, although it is still a distant second in terms of adoption.

Businesses use customized formulas to generate scores tailored for their needs. Even so, your consumer score reflects generally how potential lenders see you, since it is based on the information lenders have provided to the credit reporting bureaus.

Score Ranges and What They Mean
Most credit score providers use a score range from 300 to 850. Based on that, here's what you can expect:

  • 760-850: You're golden and will get the best interest rates on loans.
  • 710-760: Though you're not quite a VIP, qualifying for competitive offers is no problem.
  • 650-710: Approval is easy, but platinum status isn't likely.
  • 580-650: You qualify for credit at subpar rates and so-so terms.
  • 580 and below: Brace for denial and/or loan-shark rates.

What Factors in to My Credit Score?
Based on the FICO scoring formula, here are the things that determine your credit score, how each piece of information is weighted, and tips on optimizing your score.

Your payment history (35%): Your bill-payment habits -- whether you pay your obligations on time or have skipped some payments -- is the most important factor in calculating your overall credit score.

Advice: Pay your bills. On time. Every single time. If you can't cover the entire amount you owe, at least send the minimum amount due. And if you know your payment will be late, call your lender and explain, and he or she might give you a free pass, just this once.

Amounts owed (30%): Your credit utilization is based on the number of accounts you have open and how much money you owe compared the amount of credit extended to you.

Advice: In the banking world, a debt-to-available-credit ratio of around 30% is "acceptable," and red flags start waving when it exceeds 50%. Our advice: Keep your debt to below 10% of your limit, especially before going into any loan situation.

Length of credit history (15%): The longer your borrowing history -- particularly if you've been a responsible, card-carrying citizen -- the better your score. Factoring into this measurement is the total length of your credit history as well as the average length of time your existing accounts have been open.

Advice: If you have old cards, don't let them gather dust. The formula looks at both the age of the account, as well as how long it has been since the line of credit was used. And don't close accounts willy nilly. It cuts off your ability to build up your history and can have a negative effect on your debt-to-credit ratio mentioned above.

New credit (10%): Lenders like loyalty. If they see you applying for lots of credit at once, they'll tighten their purse strings and fire a few warning shots at your credit score.

Advice: Take great care when opening and closing accounts. Opening too many accounts too quickly will lower the average length of time your existing accounts have been open, and will drop your score. Also keep in mind that every line of credit you apply for will stay on your record for at least seven years, even if the account is open only for a day or two.

Types of credit use (10%): Scoring models look for a healthy mix of installment loans (e.g., car loans), revolving debt (credit cards), store charge accounts, and things like mortgages. However, this is not an excuse to go on a shopping spree for new credit.

Advice: Trying to quickly add variety to your borrowing portfolio can put you in a worse situation than where you began. Remember, when you apply for loans, you'll experience a short-term drop in your score. And then there's the money: Paying interest or annual fees or other costs of borrowing just to add some cards to your credit portfolio is almost never a good idea.

The article What Is a Credit Score? originally appeared on Fool.com.

Dayana Yochim has no position in any stocks mentioned. The Motley Fool recommends American Express. The Motley Fool owns shares of Capital One Financial. and JPMorgan Chase. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.