Credit scores are important factors in many personal financial situations. A person's individual credit score is based on how they have obtained and paid their credit obligations in the past; the credit score is computed using a standard formula that measures the credit risk associated with an individual.
The most commonly used credit score is known as the FICO score, which is an acronym for Fair Isaac Corporation. Founded in 1956 by Bill Fair and Earl Isaac, FICO is the developer of the formulas most often used to assess credit risk.
FICO itself does not track a consumer's credit history; this job belongs to the three major U.S. credit bureaus: Equifax, Experian, and TransUnion. These three organizations are for-profit companies that have gigantic databases containing credit histories on almost every U.S. resident. The credit bureaus obtain credit information from credit card companies, lenders, and banks and consolidate this information into a credit record for each individual.
While the three credit bureaus are not part of the federal government, they are regulated by the Fair Credit Reporting Act (FCRA), which exists to protect consumers and their specific credit files. In addition, many individual states have their own versions of credit protection laws.
Each person's FICO score is derived from five major factors. The weights of the five categories that make up a credit score are:
A consumer can improve their credit score by establishing several credit accounts with organizations that report monthly payments to the three credit bureaus. In addition, credit payments must always be made before the due date, since even a single slightly-late payment can reduce a credit score. If a consumer carries a balance on a credit account, a low balance that is a small percentage of the available credit for the account will have a more positive impact on the credit score as compared with a higher balance.
There are a number of factors that can hurt a credit score, including not having open credit accounts, applying for too much credit in a short period of time, and making late payments on existing accounts. In addition, having the maximum allowable balance on a credit account, having a foreclosure, or declaring bankruptcy can all negatively impact a credit score. Each of these activities indicates to financial institutions that a person might be experiencing financial difficulty and therefore is more of a credit risk in the future.