Do your lenders keep talking about your credit score, but you have no idea what the numbers mean? Don’t worry! We have got you covered. It’s not as hard as you think. In this article, you will find everything you need to know about credit scores and how they work. So, let’s gear up and start the journey of understanding credit scores.
What is a Credit Score?
A credit score is a three-digit number from 300 to 800 that lenders need to determine your credibility. It helps them evaluate if they should approve your loan and how likely you are to pay it back. In fact, you may have noticed that every borrower gets a different amount of loan and credit limit. This is because the approved amount is based on several factors and your credit score is a major part of it.
Of course, now you may be wondering how and who assigns you this number. Is it randomly generated, or is there some science to it? Keep reading and find out the answer.
How is a Credit Score Calculated?
Your credit score is typically calculated using a FICO scoring method that uses the information on your credit report and assigns a score to you.
There are three nationwide credit bureaus (Equifax, TransUnion, and Experian) that track your credit history, paybacks, and new loans. All lenders, landlords, etc., send your details to these credit bureaus and regularly keep your report updated. Since there are three companies, you may sometimes have three different scores. However, this is completely fine and quite common for many people. This happens because some lenders have associations with a particular bureau and only send information to them. Furthermore, your credit score could differ because not all bureaus use the FICO scoring model.
Now let’s have a look at the factors the Fair Isaac Corporation (FICO) considers when assigning a credit score. Remember, these variables change according to the person being evaluated. For instance, if a person applies for a student loan straight out of high school, their credit history would be different from someone who has never applied for a loan. Hence, their credit will also be calculated with different factors.
That said, the following are the factors typically used to calculate a credit score for a person who has been borrowing for some time now.
Your Credit History
Your credit score is 35% dependent on your credit history. Of course, they want to see if you have paid off your previous credit. This is the easiest way to see whether a person is reliable and responsible enough to carry debt. Regular payments indicate that the borrower can be trusted to fully pay back a loan.
Total Amount Owed
30% of your FICO scoring is based upon the total amount owed. Every person is allotted a credit limit they can get, and FICO observes how much credit you are currently dealing with and what’s left over. This is your credit utilization ratio. The lower it is, the better. If you have utilized a large portion of your limit, lenders see it as a risk because they assume you might have trouble paying it back in the future. Hence, it can affect your score negatively.
Length of Credit History
The length of your credit history counts for 15% of your scoring and determines how long it has been since you opened your first credit account. Generally, it is considered less risky if you have a long credit history because the data can be used to consider your credit worthiness. On the contrary, less data means more risk, which is why the criteria for evaluating new borrowers are different, as mentioned above.
Types of Credit
Your credit mix makes up for 10% of your credit score. This includes the different types of credit that you have taken like mortgage loans, credit cards and installment loans, etc. The different credit just shows that you have borrowed different kinds of credit, and are making regular payments on all of them.
New Credit
Similar to the credit mix, new credit also counts for 10% of your credit score. FICO checks if you have any credit accounts in process or whether you have borrowed any new credit. It can be alarming if someone with a short history has recently opened multiple accounts because it shows that they might not have the intention of returning the money borrowed.
Okay, so now you know how you were assigned the credit score you currently have. Now let’s look at what it means to have that particular score
What Does Your Credit Score Mean?
The credit score you currently have would be between 300 to 800. The higher your score, the more likely you are to get credit. It can be very challenging to get credit with a bad score. Hence you should keep a track of your credit. You need to ensure you are paying your bills on time and not exceeding your credit. Furthermore having a good credit score also means that you might not be charged very high interest. On the other hand, if you have an average or below-average score, your interest rate would be high because of the risk involved.
Here is how you determine whether you have a good credit score or bad:
800 to 850: Excellent
740 to 799: Very Good
670 to 739: Good
580 to 696: Fair
300 to 579: Poor
Most of your personal financing is done through your credit score so make sure that you are doing all the right things to maintain your score. Try and stay well above 700 so you don’t fall through for any applications that you may have in progress.
Wrapping Up
Credit scores are an important aspect of personal finance. Hence it is important to understand how they work. You will only be able to progress financially if you truly know how to manage your credit score. Even if you have bad credit, there are some things you can try to improve your score. It can be a long and difficult process but if you stick to paying your bills regularly and reducing your debt, you just may get a renewed updated credit score in a couple of months.
