This blog is part of the blog series “How to start your personal finances from 0”
1- The basics
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Credit Score 101
When you want to purchase a home of your own, you will typically require credit. Similarly, if you want to purchase your own vehicle, you will require credit. From funding your house remodeling project to paying for your kids’ education, you will usually require credit. To obtain the credit you need at favorable terms, you will need to have a good credit score. In many ways, this three-digit number is the basis on which lenders will examine all your requests for additional credit.
What is a Credit Score?
For the uninitiated, a credit score is a three-digit number. It denotes the creditworthiness of a person. In particular, it gives lenders an idea about the likelihood that the person will be able to repay any debts taken in a timely manner. So, whether you want to take out a mortgage or obtain a new credit card, lenders will check your credit score and verify your credit history before giving you a line of credit.
Credit scores typically range from 300 to 850. The higher your score, the better your chances of getting credit at terms that favor you. Within the range of 300 to 850, several categories of credit scores exist. These categories usually comprise:
- Below 600 – Bad Credit
- From 600 to 649 – Poor Credit
- From 650 to 699 – Fair Credit
- From 700 to 749 – Good Credit
- 750 and above – Excellent Credit
However, it is worth mentioning that different lenders can use different credit scores when trying to determine whether to give you credit. Therefore, it is quite likely that a score that one lender deems as ‘good’, might be ‘fair’ in the eyes of another lender. In addition, the credit ranges specified above are not permanent. Therefore, depending on their business procedures, lenders might offer variable terms and volumes of credit to people with similar credit scores.
Which Credit Scoring Models Do Lenders Typically Refer to?
Throughout America, several different varieties of credit scoring models exist. Many banks and financial institutions have formulated different credit score models. These institutions rely on their own criteria for devising these models. So, it is more than likely that you have different credit scores based on the model used by a specific lender. Keeping track of or obtaining your credit scores from all the models in existence could well be impossible. However, it is easier to focus on some of the more important credit scoring models that most lenders typically use when they decide on providing credit.
The credit ranking scores that you must be aware of include:
- The FICO Score: Introduced in 1989 by Fair, Isaac and Company (FICO), this score is quite popular with most banks and credit providers. Information contained in the consumer credit files of the three national credit bureaus (e.g. Experian, Equifax and TransUnion) form the basis for this score. A person’s credit file could contain different information at each of the credit bureaus. As such, the person’s FICO score could vary based on the bureau that provides the information to FICO.
- The Vantage Score: Experian, Equifax and TransUnion introduced this credit scoring model in 2006. This model focuses on depicting a more accurate picture of a person’s financial health. This score typically considers the last 24 months of credit activity.
- The CE Score: Published by CE Analytics, this scoring model has a range of 350 to 850. This model provides scores ranging from 330 to 830, based on payment history, credit utilization, total balances etc. A sister company, Quicken Loans, uses this score for making credit determinations. This is why this model continues to be in use.
- The TransRisk New Account Score: This score relies on data from TransUnion for determining the creditworthiness of an individual. The developers devised this model for ascertaining new account risk. Thus, it is not as popular as other scoring models.
- The National Equivalency Score: Developed by Experian, this model assigns consumers with scores ranging from 0 to 1,000. Factors that contribute to this score include credit length, credit mix, payment history etc. Experian provides an alternative score range of 360 to 840 as well. This is merely to make the score more compatible with the FICO model
- The CreditXpert Score: The developers of this scoring model aimed at helping businesses approve new account candidates by inspecting credit reports. This scoring model believes that by improving the scores of customers, businesses can approve a higher number of customers.
What Factors Does the FICO Credit Score Typically Consider for Determining the Creditworthiness of an Individual?
Credit has become an inseparable part of contemporary lifestyles. Whether you need a new credit card or a mortgage, you will need to apply for credit. On receiving your application, lenders will check your credit score to ascertain the risk they will incur by lending you money. For this, they will typically order a credit report that lists your credit score. Although it is only a three-digit number, your credit score provides a summary of your credit risk to the lender.
As mentioned earlier, FICO scores are among the most widely used credit scores in the country. Estimates suggest that approximately 90 percent of lenders use FICO scores for making a number of credit-related decisions each year. FICO scores usually range from 300 – 850. The higher your FICO score, the lower the risk you pose to the lender. This score considers several different items of credit data that appear in your credit report. This data will typically include aspects such as:
Your Payment History: This parameter provides information on the timeliness of your previous credit account payments. The lesser the number of late payments you have, the more you will score on this parameter. A few late payments will not deflate your score significantly. But, it is worth mentioning that this parameter contributes to 35 percent of your FICO score.
The Volume of Credit You Owe: When you obtain credit, you will have balances on your credit accounts. But, consuming high percentages of the credit available could indicate that you owe more than you can repay. This situation is likely to lead to late or even, missed payments. This parameter contributes to 30 percent of your FICO score.
Your Credit History: The longer your credit history, the better you will fare on this parameter. This parameter contributes to 15 percent of your FICO score.
Your Credit Mix: This denotes the different types of credit accounts that you have. Credit accounts comprise revolving lines of credit, consumer finance accounts, mortgages etc. This parameter contributes to 10 percent of your FICO score.
Your Recent Searches for Credit: If you open many credit accounts in a short span, you could become a high-risk to lenders. This is especially so if you don’t have a long credit history. This parameter contributes to 10 percent of your FICO score.
Tips for Building and Enhancing Your Credit Score
Your credit report will not only provide details on all your credit accounts and repayments. It will specify a credit score as well. This score enables lenders to ascertain the risks of lending you money. The higher your credit score, the greater the likelihood of your obtaining approval for your credit requirements. A high credit score could enable you to obtain credit at lower interest rates. Similarly, having low credit scores might disqualify you from various credit-based products entirely. Alternatively, they might make some lenders provide credit at higher interest rates. To build credit history, you will need to open new credit accounts. The simplest way to do this is to obtain a credit card. By using the card and repaying the amount owed on time, you can build your credit history.
Thereafter, focus on increasing your credit score by ensuring that you:
Obtain a copy of your credit report and ensure that it does not contain any errors that could be affecting your credit score negatively.
- Make all your payments in full and on time as even a single missed payment could impact your credit history negatively.
- Set up payment reminders that notify you when your credit payments become due – this would help you eliminate the occurrences of late or missed payments.
- Keep your credit utilization low i.e. below 30 percent or so.
- Credit utilization denotes the percentage of your total available credit, which you are using.
- For instance, if you have a total credit limit of $1,000 and you are using $500, your credit utilization is 50 percent.
Don’t have any bankruptcies, foreclosures, tax liens, collections and civil judgments featuring in your credit reports as these could affect your credit score for as long as seven to 10 years.
Establish credit accounts as early as possible to improve the age and the length of your credit history.
Avoid closing credit accounts unless it’s absolutely essential.
Avoid opening new credit accounts unnecessarily if you don’t plan to use them and,
- Avoid applying for new lines of credit or loans, as each hard inquiry into your credit history will affect your credit score negatively.
You will need to avoid falling into a debt trap by taking on more debt than you can afford to repay. For this, ensure that you purchase only what you require. Thereafter, prepare a budget that lists your earnings and expenses. Formulate a plan that helps you to repay debts with higher interest rates first. The lesser money you owe, the more financially secure you will be.
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As mentioned earlier, credit has become an essential aspect in contemporary times. However, obtaining it at favorable terms is not as easy as it might appear. In case you require additional details on your credit score or need assistance in obtaining credit, let us know. We will be glad to help you accomplish your objective.