Credit Scores: How They Work & How to Build One

Overview

A credit score is a numerical model used to estimate the likelihood that a borrower will repay debt on time. It is not a measure of wealth, income, intelligence, or character — it is a statistical risk score.

This chapter explains:

  • How FICO scores are calculated
  • The exact weight of each factor
  • What actions change your score and why
  • How credit reports work
  • How inquiries affect scoring
  • How to build credit from zero
  • How long negative items remain on your report
  • How utilization is calculated
  • How to read a credit report
  • How the system processes late payments

Everything here is mechanical, data-driven, and rule-based. No judgment, no behavioral advice — only how the scoring system operates.

1. Credit Reports vs Credit Scores

A credit report is a detailed history of your borrowing activity stored by the three major bureaus:

  • Experian
  • Equifax
  • TransUnion

A credit score is a numerical model (usually FICO) that uses data in your credit report to calculate a score between 300 and 850.

You have:

  • 3 credit reports
  • Many scores
    (because banks use different FICO versions)

Most lenders use FICO 8 or FICO 9 for general lending and FICO 5/4/2 for mortgages.

2. The FICO Score Formula (Exact Weighting)

FICO scores are calculated using five weighted categories:

Factor Weight
Payment History 35%
Amounts Owed (Credit Utilization) 30%
Length of Credit History 15%
New Credit (Inquiries) 10%
Credit Mix 10%

Below is what each category actually means — with numeric examples.

3. Payment History (35%)

This is the single most important factor.

Payment history tracks:

  • On-time payments
  • Late payments
  • Delinquencies
  • Charge-offs
  • Collections
  • Bankruptcies

3.1 Late Payment Timelines

A payment is reported late only after 30 days past due.

  • 30 days late
  • 60 days late
  • 90+ days late

Severity increases with each threshold.

3.2 Example of Score Impact

(| approximate ranges; individual models differ |)

  • 30-day late: −60 to −110 points
  • 60-day late: −80 to −140 points
  • 90-day late: −100 to −160 points

The first late payment is the most damaging.

3.3 How Long Late Payments Stay

Late payments remain on reports for 7 years.

4. Amounts Owed (Credit Utilization) — 30%

Utilization measures the balance relative to credit limits on revolving accounts (credit cards, store cards).

Utilization = (Total Balances ÷ Total Limits) × 100%

Example A

  • Limit: $1,000
  • Balance: $200
  • Utilization: 20%

Example B

  • Limit: $1,000
  • Balance: $800
  • Utilization: 80% (score drops)

FICO evaluates:

  • Individual card utilization
  • Overall utilization

Both matter.

4.1 Utilization Effects (approximate)

  • 1–9%: optimal
  • 10–29%: generally fine
  • 30–49%: moderate impact
  • 50–79%: significant impact
  • 80–100%: severe impact

Utilization is measured on the statement closing date, not the payment date.

5. Length of Credit History (15%)

Measures the age characteristics of your credit profile:

  • Oldest account age
  • Youngest account age
  • Average age of accounts (AAoA)

5.1 Example: Average Age Calculation

Three accounts:

  • 6 years old
  • 3 years old
  • 1 year old

AAoA = (6 + 3 + 1) ÷ 3 = 3.33 years

5.2 Score Impact

Younger average age → lower score
Older average age → higher score

This factor changes slowly over time.

6. New Credit (10%)

  1. Hard inquiries
  2. New accounts opened

6.1 Hard Inquiry Mechanics

A hard inquiry occurs when:

  • Applying for a credit card
  • Applying for a loan
  • Opening certain new accounts

Impact:

  • −3 to −8 points typically
  • Effect fades after 6 months
  • Completely gone after 12 months
  • Inquiries remain on report for 2 years but only score for 1 year

6.2 Rate-Shopping Protection

Auto loan, mortgage, and student loan inquiries within a 14–45 day window (depends on FICO version) count as one inquiry.

6.3 New Account Impact

Opening new accounts temporarily reduces:

  • Average age
  • Stability indicators
  • Score (small temporary dip)

7. Credit Mix (10%)

FICO prefers a combination of:

  • Revolving credit (credit cards)
  • Installment loans (auto, student loans, mortgage)

This factor has the smallest weight but can influence the score, especially for thin files.

8. How to Build Credit From Zero

Building credit is mechanical — you need data in your report.

Here is a purely structural path:

8.1 Step 1: Open a Starter Credit Product

  • Secured credit card
  • Student credit card
  • Retail card (less ideal but functional)

8.2 Step 2: Keep Utilization Low

If limit = $300, keep statement balance ≈ $20–$40.

8.3 Step 3: Add a Second Account After ~6 Months

Opens up credit mix and increases available limits.

8.4 Step 4: Maintain 12+ Months of On-Time Payments

This builds enough history for most lenders.

9. How Credit Scores Change Over Time

9.1 Early Stage (0–12 months)

  • Score highly sensitive to utilization
  • Hard inquiries matter more
  • Short history limits total score

9.2 Middle Stage (1–4 years)

  • Scores stabilize
  • Length of credit becomes meaningful
  • 700+ range achievable with good data

9.3 Mature Stage (5+ years)

  • Long history boosts score
  • Late payments still hurt, but profile is stronger
  • 760–800+ achievable

10. Negative Events: Timelines & Impact

10.1 Late Payments

Reported at 30+ days late
Stays 7 years

10.2 Collections

Reported when debt is sold or assigned
Stays 7 years
Paid vs unpaid often treated similarly (varies by scoring model)

10.3 Charge-Offs

Stays 7 years
Severely impacts score

10.4 Bankruptcies

Chapter 7: stays 10 years
Chapter 13: stays 7 years

10.5 Hard Inquiries

Impact lasts 12 months
Visible for 24 months

11. How to Read a Credit Report

  • Personal identity information
  • Trade lines (accounts)
  • Balance history
  • Payment history
  • Hard inquiries
  • Soft inquiries
  • Public records
  • Collections

You should verify:

  • Payment statuses
  • Balances
  • Dates opened
  • Credit limits
  • Whether accounts are reported correctly

Errors are common, especially in:

  • Collection accounts
  • Student loans
  • Authorized user accounts

12. Practical Examples

Example 1: Utilization Spike

Limit: $1,000
Balance: $850
Utilization: 85%

Score drop: −40 to −80 points (approx.)

If paid to $20 before statement closes:
Utilization = 2% → score rebounds.

Timing is critical.

Example 2: Opening a New Account

Before opening:

  • 3 accounts
  • AAoA = 4 years

Open new card:

  • New AAoA = (4 + 4 + 4 + 0) ÷ 4 = 3 years

Score impact:

  • −5 to −15 points temporarily
  • Recovers over months as age increases

Example 3: First Late Payment

  • Score drop: −80 to −110 points
  • Remains for 7 years
  • Impact lessens after ~2–3 years of on-time payments

Example 4: Building Credit From Zero at Age 18

Month 1: Open secured card
Month 6: Add second card
Month 12: Add low-limit installment loan or self-builder account
Month 18–24: Score likely in 700+ range with responsible use

Key Takeaways

  • FICO scores are determined by five weighted factors.
  • Payment history and utilization carry the most weight.
  • Utilization is based on statement-closing balances, not payment date.
  • Inquiries matter for 12 months and are grouped for rate-shopping.
  • Credit history length grows slowly and is essential for high scores.
  • Negative items last 7–10 years depending on type.
  • Credit can be built systematically with proper account structure.