What Is a Credit Score? How Is It Determined?
A credit score evaluates an individual’s financial records to determine their sense of responsibility in regard to finances. A high credit score means that you are responsible with the finances and a there is a low risk to provide a loan. Alternatively, a low credit score means that you are irresponsible with finances and a there is a high risk to provide a loan.
A credit score is determined based on your number of accounts and the history of your payments. It is evaluated using Fair Isaac Corporation (FICO) method. Experian, TransUnion, and Equifax are three major credit bureaus responsible for evaluating the credit score. The lender uses credit score to identify the risk involved. Typically, the credit score ranges from 300 to 850. A lender uses a credit score as a key decision-making tool. They judge the interest rate, credit limit, and approval of loan on the basis of a credit score.
The credit score is determined after the consideration of the following aspects based on their weightage.
1. Prompt payment of debt (35%)
2. Less borrowing (30%)
3. Duration of open credit accounts (15%)
4. Combination of all your credit cards (10%)
5. The frequency of using new credit (10%)
Typically, a score above 740 tends to have lower interest rate and a higher chance of loan approval.
The standards for credit scores are:
Exceptional: 800 to 850
Very Good: 740 to 799
Good: 670 to 739
Fair: 580 to 669
Very Poor: 350 to 579
The credit score evaluated by Experian ranges from 0 to 999. Its standard for the evaluation of credit score is:
Excellent: 961 to 999
Good: 881 to 960
Fair: 721 to 880
Poor: 561 to 720
Very Poor: Below 560
Similar to FICO, its credit score also ranges from 300 to 850. TransUnion uses the same criteria for categorizing a credit score, but its weightage system differs. The following aspects are used by TransUnion to determine a credit score:
1. Payment history (40%)
2. Credit utilization (20%)
3. Credit history (21%)
4. Recent balances (11%)
5. New credit accounts (5%)
Equifax follows the FICO method to evaluate the credit score. The only distinction in its evaluation is the percentage of a new method (10-12%) and the credit history (5-7%).
What Leads to a Poor Credit Score?
A 2016 report suggested that 30% of Americans have a poor credit score. There might be multiple reasons behind this daunting statistic. Largely, it is due to the non-payment of debt. There are individuals who pay nothing at all.
Moreover, a charge-off can be the worst thing to happen to your credit. Even though you owe money to a credit card company, it can close the account because you have not paid any debt. This is referred to as a ‘charge-off.’ After a charge-off, you still owe money and are unable to pay it back. When the creditors are unable to collect payment from you, they send a third-party collector. Your account is reported to collections which has a negative impact on the credit score.
Other factors like defaulting on a loan are similar to charge-offs. They signify your inability to pay off the loan. Bankruptcy and foreclosure can also have a negative impact on your credit score.
At times, your credit score might be dropping and you have no idea, why? The reasons behind this strange decrease could be subtle factors like seeking credit or high credit usage. You may have been using the credit too frequently which could have increased the utilization ratio. Payment of student loan, missing a payment, and closing an old credit account are other factors affecting the credit score.
The aforementioned situations can be the reason behind a poor credit score or a decreasing credit score. A poor credit score will decrease your chances of getting a loan approved.
Keeping a Better Credit Score
A high credit score means you are good at managing credit. Typically, a lender views this as a positive sign to approve your loan. To maintain an exceptional credit score you should take care of the following things.
A. Mostly, the people are recommended who pay the debts on time without any delay. If you continue making the payments, even if they are minimal on a schedule, the score will reach 800 in no time.
B. The portion with the significant weightage is, how much of your credit is used? An exceptional credit score holder does not use more than 7% of their credit.
C. If you have any open credit accounts that are not being used, close them. A long credit history can damage your credit score. Closing them will help you improve the utilization ratio, which is good for the score.
D. Multiple credit card accounts that are diverse have a positive impact on your credit score. Keep credit cards for auto loans and mortgages and manage efficiently. The lender will know that you are good at handling the credit.
E. Lastly, avoid opening new accounts right after you have closed an account. According to FICO, these tips would eventually lead toward an 800+ credit score. It will decrease the interest rates on your future loans. Each credit decision can affect your ultimate credit score, so think wisely.
If you are amongst the 14% of the individuals that do not have any credit score, this is probably because you have never used credit. This is preferably better than having a poor credit score. You can create better credit history as you go along. Paying off all the balances without any credit is still recommended.
Apart from a Loan Rejection, How Else can a Bad Credit Score Negatively Affect You
Everyone knows how a bad credit score can lead to loan rejections (long term loans as well as short term loans) and higher interest rates. However, do you know that it can affect your personal and public life as well? It can, and that is the reason why it is important to maintain a good credit score. Following are some ways how a bad credit score can negatively impact your life.
A Bad Credit Score Can Cost You a Job
Demos, a US-based research organization whose focus include economic security and economic progress, conducted a survey among job applicants. They found that one out of every four applicants had their credit run by the potential employers. The survey also found that one in seven were denied a job because of poor credit. A number of companies, especially the financial institutions, nowadays check the credit report of prospective employees during the process of hiring. It is the take of many financial companies that a person who cannot manage his/her own finance would not be a suitable employee for them. Certain government jobs require a security clearance, which includes running a credit report. A bad credit report can lead the government agency to reject your job application.
You May Be Denied for Housing
It is against the law for landlords to run the credit of prospective tenants, however, many of them do it, especially the landlords of those neighborhoods where the demand for rental apartments/homes is high. If they find that you have a bad credit report, they will not rent their apartment/home for you. Landlords, in general, are of the opinion that a person with a bad credit report is less likely to make payments on time.
You May Pay Higher Insurance Premiums with Poor Credit
85% of home insurers and 95% of auto insurers consider credit reports while deciding on the insurance premiums, according to NAIC (National Association of Insurance Commissioners). If your credit report is bad, then expect a higher insurance premium from your insurer. Again, it is the same reason, insurers also will take you for a person who does not make payments on time. Some auto insurers even consider people with a bad credit report as reckless, high-risk drivers, hence the need for a higher insurance premium.
A Bad Credit Score Keep You From Getting A Cell Phone
Cell phone carriers look at credit reports before they approve new contracts. If your credit report is not ideal, they will not approve your contract. The reason is the same, a bad credit report will make them question your ability to make payments on time.
All of this can lead to potential strain in your personal relationships as well. So, if you have a good credit score, maintain it. If your credit score is not good, try to improve it as soon as possible.
Simply put, you should pay the debts and bills on time. Utilize the credit responsibly, rather than wasting the entire amount. Lastly, if you have multiple accounts, learn how to manage each of them. You need to analyze the lifetime of the account. Keeping control of your credit is instrumental because even the smallest difference can affect the interest rate.