The purpose of a credit score is to provide a kind of grade. Are you a good bet or are you a bad bet for a lender. If you think about it lenders only make some % on their money each year, if a loan goes bad they have the chance to loss all the money, so they have to be very accurate about who they can trust and who they can’t. Back in the day lenders were much closer to their clients, this was a time when you needed to go to your local bank to get a loan. The person at the local bank, would have known your family, or they would be able to ask around about what kind of person you are. Is this person responsible? Do they keep their promises? Are they honest? If you think about it, that is a great way to extend credit, you would have a really good idea of how risky lending a person money would be. On the other side of that equation, if you made the local banker angry, or they had something against you, then getting a loan could become very hard.
As time has gone on and more and more of us live in huge metropolitan areas, the chance your banker knows you personally is very small, in addition, that subjective way of measuring your worthiness is frowned upon and doesn’t not fit in a large corporate bureaucracy. So new methods were developed to figure out who to give money to and who not to. The credit score is one of those newer methods. It seeks to measure all those character aspects of a person using just data available from your financial life.
So how does it aim to estimate what kind of person you are? Well in several ways. One, and the most commonly known is, on time payments. If a person is making their payments on time, it says three things, one they have the money to cover their debts, two this may mean they plan well in that they haven’t over stretched themselves, and three it could mean that even if they are having money troubles they are willing to do what needs to be done to keep paying their debts. These are all very desirable things from a lender’s perspective.
Another way a person is measured in their credit score, is open credit. So the idea is if a person has a lot of credit available to them, but they aren’t using it then that probably means things are going well. It also could mean they are cautious and know that having credit available to them could help them weather a storm. Both good attributes for a lender to look for.
The credit score also looks at how long your credit has been established. This helps a lender see if your on time payments, and open credit are just a blip or are a lifetime reflection of the kind of person you are. This also helps to prevent fraud, because establishing a long history of credit is a big ask for someone trying to pull a fast one on a bank.
Finally, recent inquires weighs into the credit score. The idea here is that if you are shopping around for a loan, either, maybe things have turned for the worse and your other credit measures are about to reflect that, or that maybe you have been shopping around and other lenders see something that isn’t obvious, so better be safe than sorry.
All of these measurements are very rough and blunt instruments. There are all sorts of reasons why they can and do incorrectly measure how likely a person is to go bad on a loan. BUT overall they do work fairly well, and that is why lenders use them so often. Now a days lenders who are at the forefront are trying to go beyond credit scores, they are using AI, and access to social media to try and figure out who might be a good bet that a credit score might be incorrectly measuring. Hopefully means that overtime the system becomes even more fair, and doesn’t hurt those who might have just had an unlucky break.