Bad credit can affect more than just our ability to borrow money. It can influence our chances of landing a job or renting an apartment. To understand what bad credit is how it's measured and ultimately, how to repair it requires understanding how our financial system measures our credit.
It turns out that measuring our creditworthiness -- how likely we are to repay our debts -- begins with something called a credit score. People with bad credit have low credit scores.
What is a Credit Score?
To borrow money, you'll need to understand how lenders look at you. And to determine whether they'll lend to you, lenders, like banks and credit cards, use a scoring system.
A credit score is a number that lenders use to quantify how risky a borrower you are. The standard credit score is also called a FICO Score, named after the Fair Isaacs Corporation who created the standard formula.
Credit scores typically range between 300 and 850 (the higher a score, the better). Recent laws have ensured that people can access their own credit reports every year for free.
Credit scores are made up of a variety of factors to determine how likely you are to pay back a loan:
- Payment history (35%): Lenders want to see whether you've paid back other loans in full and on time.
- Amounts owed (30%): Lenders may view people who carry a lot of debt as risky -- less likely to pay back new loans.
- Length of credit history (15%): You'll get a higher credit score when you have more experience managing debt. Lenders like to see a long history of responsible borrowing.
- Types of credit in use (10%): This part of the equation looks at what type of credit a person has: credit cards, installment loans, mortgages, etc.
- New credit (10%): Applying for a lot of new loan applications in a short period of time is considered a greater credit risk and lowers credit scores.