In order to understand what a credit score does you must first have a grasp of what the credit score is. Essentially a credit score helps lenders get a good grasp on the possibility that a borrower will not meet their financial obligations. More simply put the credit score lets the lender know generally how risky of an investment it is to lend to a specific borrower. After calculating the credit score, banks and other lending institutions such as credit card companies make one of three decisions. The decisions are to deny credit, charge varying interest rates, or require one to have more extensive income and asset verification. The credit score also helps these lenders to set a limit for the amount of credit they will give.
The interest rate that you are charged on a loan is directly correlated to the credit score. One can get a more vivid image of how this relationship works by imagining a pie which is divided up between your credit score and the interest rate that will be charged on a loan. As the portion of the pie representing your credit score becomes larger (your credit score increases), the portion of the pie representing the interest rate charged on a loan becomes smaller and vice versa. One’s credit score is not the only determinant of interest rate but in general it is a good representation.
More recently the credit score has been used in new arena’s such as by the insurance companies where the rates are being used to calculate insurance rates. Others, such as landlords, merchants, and employers are beginning to use credit scores for varying reasons.
How Is Your Credit Score Calculated?
Credit score can range from 300-900 and is broken down into five categories. Thirty-five percent of the score is based on payment history, thirty percent on outstanding debt, fifth teen percent on length of credit, ten percent on number of inquiries, and ten percent on type of credit. Each of these categories is researched and calculated to come up with an individual score for each section. These scores are then added proportionately and an individual’s credit score is calculated. This number is then used to help financial institutions determine interest rates to charge certain individuals.
What affects it?
Your credit score is broken down into five categories. These five categories include payment history, amounts owed, length of credit history, new credit, and types of credit used. All of these factors are weighted differently and ultimately have an effect on a person’s overall credit score.
The main influence is payment history, which comprises 35% of a person’s credit score. A lender is primarily interested in knowing whether a potential client has paid past credit accounts on time. Credit scores take into consideration:
- Payment information on a variety of accounts – These accounts include credit cards (American Express, Visa), retail accounts (department stores), installment loans (car loans), and mortgage loans.
- How many accounts show no late payments – Having no late payments on credit accounts will establish reliability and increase your credit rating.
- Details on any late or missed payments and public record and collection items – credit scores take into consideration how late the payments were made, how recently they occurred and many there are.
- Public record and collection items – This section takes into account reports of bankruptcy, foreclosures, lawsuits and judgments, and past-due child support. Lenders weight these implications heavily. The more recently these events have occurred the more heavily they will weigh on you overall score.
The second factor that influences credit score is the amounts owed on credit accounts. This portion comprises 30% of your credit score. This section takes into account what portion of a person’s available credit is in use. This includes the following:
- The amount owed on all accounts – Credit reports reflect the total balance on your last statements, so even if you pay your bills off every month there is still a chance that your credit report will have a balance.
- The amount owed on all accounts, and on different types of accounts – Credit scores also factor in the specific types of accounts that you owe money on, such as a credit card or installment loans.
- Balances on certain types of accounts – Maintaining low balances and not missing payments allows lenders to see that a particular client is reliable, and able to manage credit. Maintaining low credit balances may be superior to carrying no balance because it shows you are responsible rather than just don’t use credit cards.
- Number of accounts with balances – The more accounts with credit balances implies a greater possibility of late or missed payments
- Proportion of total credit line in use on credit accounts – The more outstanding credit on personal accounts the harder it is to pay off and the higher the credit risk. As a rule of thumb, keep credit card balances at 25% or less of their limit.
- The balance remaining on installment loans, compared to the original loan amount – Proof that a client is paying off installment loans on time is a good forecasting measure for lenders. Paying off installment loans illustrates dependability, and good credit management.
The third category, length of credit history, consists of 15% of a person’s overall credit score. Generally, the more established a person’s credit history the higher their score will be. Past payment history allows lenders to more easily forecast future transactions. This category takes into account:
- How long credit accounts have been open– The age of a client’s oldest account, newest account and the average age of all accounts are factored in.
- How long particular accounts have been in use – The longer an account has been active the better.
- How long it has been since you have used certain accounts.
A person’s credit score is also based on new credit, which accounts for 10% overall. The following have an effect on a person’s credit score:
- Number of new accounts – Credit scores factor in they total number of new accounts a person opens up in a short period of time as well as what type of account was opened. For example, if a person opens up several credit card accounts within a short period of time this will hurt their credit score. It will especially be detrimental to those that do not have an established credit history.
- How long it has been since you opened a new account – This may be taken into consideration for specific types of account.
- Number of recent requests for credit you have made, as indicated by inquiries to credit reporting agencies – Several inquiries indicate a person may be experiencing financial trouble and seeking out options. These inquiries linger on your credit report for two years, but agencies usually only count the inquiries that display credit risk.
- Length of time since lenders made credit report inquiries.
- Re-establishment of good credit, after past payment troubles – A person can re-establish their credit and raise their credit score after a period of delinquent behavior if they work hard to make on time payments.
The final factor that affects a person’s credit score is the types of credit in use. This category consists of 10% of a person’s credit rating. Types of credit in use factor in a person’s overall combination of accounts. A person may hold credit cards, retail accounts, installment loans, and mortgage loans. Credit ratings factor in:
- What kinds of credit accounts a person holds – Is a client’s credit portfolio diverse or do they only hold one type of account. Holding a variety of accounts can increase credit ratings.
- How many of each type of account is open – Credit ratings evaluate the total number of active account and decide how many accounts is over-extension.
What it costs?
Credit Score has an affect on two very important things. First it has an effect on whether or not an individual will be able to get a loan and it also affects how much that loan is going to cost you.
For example: The interest rates for a car loan can vary based on your credit score. Depending on whether you have a high credit score or a low credit score, it will have a significant affect on how much money the average individual pays.
As shown above, having a low credit score can really have a negative effect on how much money an individual will have to pay. There are other factors that influence the interest rate you get for a loan besides your credit score. Things like the type of property you are using the loan to buy, how much of your own money (equity) is going into it, the costs the lender has to make the loan, etc; however, a person’s credit score is a big factor in this process. Banks, lenders, landlords, merchants, employers and insurance companies are all jumping on the credit score bandwagon. Of all of these, the fact that insurance rates are being determined by credit scores is causing consumers the most alarm. Insurers have found that using credit scores to predict how likely someone is to pay premiums has helped them cut their losses.
Maintaining and Building Your Credit Score:
The credit score is an unemotional, somewhat objective number that lenders use as a critical tool for standardizing lending in their industry. The score is a “benchmark number or starting point that helps lenders assess risk and determine how likely it would be for a person to whom they lend money to repay the debt as agreed” (McLaren). The scoring system is based on a mathematical formula that takes into consideration activity in your credit history. Today, insurance premiums, utility rates and even employment decisions are increasingly based upon your credit, with a poor score suggesting a lack of judgment. In order to effectively keep this score at a satisfactory level there are certain steps that can be taken that will maintain as well as build your credit score.
The step to maintaining your credit score is being able to pay your bills as soon as possible. Waiting until they are past due, or nearly past due will shave points off your score. The second step involves credit cards and the ability to use them responsibly. Carrying a balance on your credit card cannot only reduce your score, but limit the amount of money you are able to borrow from banks and loan offices. If an especially large balance does happen to accumulate, the particular credit card in use should be put into a drawer for month or two until the balance can be paid off. Even though your credit cards provide an easy way to pay, keep in mind that you are increasing your debt with every swipe. Is the possibility of “negatively affecting your credit score now worth the risk of not being able to make a substantial purchase in the future?” (McLaren). This is a question you must ask yourself before making decisions that may have serious consequences and jeopardize your financial position.
The next step in maintaining your credit score coincides with the previous ones mentioned. You not only need to keep your cards at a zero balance, but carry as few credit cards as you can. Too many will mean a large available credit pool, which means you’re in danger of over-extending yourself. The fourth step to follow involves being proactive in your credit rating. Checking your report continuously guarantees an early detection of any inaccurate information; if anything is found to be amiss contact the local police department. This report could be the first step to credit repair. Another common misconception concerning your credit score is the belief that moving from one account to another will improve your credit; this is not always the case. The longer you have an account the more credible you may seem to lenders. However, if you do happen to close an account, make sure “it was closed at your request…those closed by lenders due to non-payment look very bad on a report” (Malaren). The next step to maintaining your score is to make sure that payment plans are only changed when absolutely necessary. For example, payments on long term debt, such as auto loans and mortgages should only be altered with the advice of your lender. Finally, one must never run away from obligations and never put things off. This is an excellent way to ruin your credit as well as your future.
As alluded to before, “credit scores are designed to measure the risk of default by taking into account various factors in a person’s financial history” (Sondra). Maintaining your credit is extremely important, but building this score can be advantageous. The first step to accomplishing this task is to apply for a credit card. This may seem to contradict previous statements; however, it is the easiest way to establish a credit history which reveals your ability to pay for things that you buy or use. Choose a card that offers the lowest interest rate, and if possible one that offers a cash back percentage on purchases you make. Once you have decided to get a card you need to check your budget. Determine how much “cash you have left over at the end of the month, for an added purchase expense” (Sondra). When you charge on your credit card, do it in place of cash, and make sure that you do not charge more than you can actually afford to pay at the end of the month. The last thing you want to do is be established as a “late payer.”
If you feel that this method does not work for you, follow another way of establishing credit. For example, open a checking or savings account. Lenders see bank accounts as a “sign of financial stability,” and there is a strong possibility that banks will extend credit in other areas of their establishment. Another idea to consider involves contacting your local bank or credit union. Open a charge account with them and deposit a specific amount of money into the account. This is called a “pre-paid charge account,” and must be monitored closely (Sondra). Charge normally, but watch the balance because this method only allows you to charge up to the amount you deposited.
Maintaining and building your credit score can be relatively easy if certain steps are followed, and spending behaviors are modified. Always be proactive and check constantly for any inconsistencies within your report. Never let your debt get out of control, and focus daily on improving your financial stability.
McLaren, Christopher. How to Maintain Your Credit Rating. 7 December 2006.
WikiHow. 9 March 2007.
Sondra C. How to Build Good Credit. 20 February 2007. WikiHow. 9 March 2007.
Credit Score Errors
It is not uncommon for there to be an error in a consumer’s credit score. In March 1999, the U.S. Public Interest Research Group conducted a report on a small sample of people. Their discoveries were as follows:
- 70% of reports in a sample group contained some type of error
- 29% contained serious errors that could be used to deny credit
- 19% contained accounts that could not be identified or did not belong to the consumer
- 26% contained credit accounts that were closed by the consumer but listed as open
Errors in a credit report will lead to the score errors. Numerous errors can occur in the reports and include but are not limited to the following. Some consumers do not insure they use the correct name when they apply. A consumer whose name is James but goes by Jim should be sure to use James during the application process. Clerical errors during entry of data, incorrect social security numbers, and loan/credit card payments applied to the wrong account are just a few more of the many errors that can occur. If a consumer believes his or her credit score is incorrect, they should notify their credit reporting agency immediately. These agencies are required to investigate the potential error and respond to the consumer’s request within 30 days. Consumers may see their credit scores but will not know everything used to calculate the score. Because of this, it is extremely difficult for consumers to have any idea where an error has occurred.