Credit providers use credit scores as a way to gauge risk. Credit scores based on payment history are a predictor of how well borrowers will pay their debts in the future.
By understanding credit scores and the way they work, you’ll be better prepared to make necessary changes to your financial habits and the way you make credit choices. Improving your credit score ranking can be easy once you know how credit scores are calculated and what lenders look for when making credit decisions. While improving credit is not an exact science, there are things consumers can do to raise their consumer credit scores over time.
The FICO Scoring System, 300-850
The FICO Scoring system is the standard scoring model for consumer credit, used by most lenders. FICO stands for Fair Isaac Corporation, the company that created the specific scoring model, and owns the rights to the formula used to calculate personal credit scores. While FICO scores range from 300 to 850, there are many factors that contribute to a specific number.
These 5 Critical Factors Affect Your Credit Score
1. Payment history reflects the account holder’s pattern of paying the monthly payment on time. Most lenders only report payments to the credit reporting agencies that are late after 30 days from the due date. The number of times a late payment was made, the number of days the payment was late, and when the most recent late payment occurred are all factored into payment history.
2. Total debt considers the sum total of all current credit balances, as well as the “usage ratio”. Usage ratio refers to the percentage of credit currently in use compared to the amount of credit available. A usage ratio that is high will negatively affect individual credit scores.
3. Length of credit history applies to the length of time for which an account has been open. Negative payment history is weighted differently for new accounts than that of long established credit. Derogatory credit reported on a new loan or credit card brings down a credit score further than that of late payment history on an older credit card or line of credit.
4. New credit takes into consideration any credit accounts opened recently and credit inquiries made to the consumer credit file. A credit inquiry is created every time a consumer applies for a loan or credit card. An entry is made in the credit profile indicating that a credit report has been “pulled” by a potential lender or creditor. If too many credit inquiries appear on a consumer credit report in a short period of time, this could signal to a lender that new credit accounts have been opened and the consumer is over indebted. This can also lower a credit score considerably.
5. The type of credit used is taken into consideration when determining a credit score. Bankcards and bank loans that the consumer pays on time help raise a consumer credit score. Loans originated from finance companies are considered in the credit score as well. Bankcards and loans from major banks contribute positively to your credit score, while loans from finance companies generally lower a credit score.
How Credit Scores Are Used
Credit scores play a critical part in the credit and lending process. Credit providers base their decisions about whether to lend money to borrowers in part on credit scores. High scores not only signal to the lender that you will likely pay your monthly payment on time, but will also be used to determine the interest rate you get, on the money you borrow. Since individuals with lower credit scores represent higher risk, they get assigned higher interest rates. This way, the lender will not lose money overall if even a few consumers default on their loan.
8 Credit Score Ranges—What They Mean to You and Your Lender
Credit scores fall into ranges that are determined by individual lenders. These ranges each represent a different degree of risk that the lender will take when lending money.
Perfect Credit (800-850)
A credit score in this range indicates to lenders that you’ve utilized a good mix of loans, credit cards and personal lines of credit through the years, and regularly pay on time. A score this high will afford you the best borrowing opportunities at the best interest rates.
Excellent Credit (750-799)
With a credit score in the excellent range, you’ll most likey qualify for all loan and credit card products available in the lending marketplace. Terms offered will be at competitive rates and allow you the purchasing power you deserve. A less than perfect credit score may indicate high debt-to-income ratio, even if you pay your bills on time.
Good Credit (700-749)
Some lenders consider credit scores above 660 good, while others make the break at 700. Mortgage lenders will view your score as “prime” and you’ll get a good interest rate at only about a quarter of a percent higher than those with excellent credit scores.
Fair Credit (640-699)
A fair credit score indicates you’re ability to manage your finances most of the time. While you may not qualify for the best interest rates on credit cards and loans, you’ll still be able to get an FHA home loan with a minimal down payment. With just a little boost to your credit score, you’ll save money on interest however.
Poor Credit (571-639)
Poor credit definitely impacts your ability to finance many purchases including autos, furniture, and appliances. While many car dealers will approve loans for poor credit, the interest rates you’ll get will add thousands of dollars to your overall costs.
Very Poor Credit (500-570)
Very poor credit may put you out of the running for some loan and credit products, though high-risk lenders may still work with you. Getting a secured loan tied to an asset like an auto or home that’s built up equity will be much easier than an unsecured line of credit. Lenders may require a co-signor and make other stipulations such as direct deposit paychecks for consumers with very poor credit.
Bad Credit (400-499)
A bad credit score indicates high risk to a lender, making it difficult to get a loan or credit card. Homebuyers with bad credit cannot qualify for a government backed FHA loan, and many will face large deposits and the need for a co-signor when renting an apartment. A score this low may be the result of a bankruptcy, foreclosure, or multiple judgments.
Very Bad Credit (300-399)
Scores in this range make borrowing off limits for many consumers, and can negatively impact employment opportunities as well. If you’ve borrowed in the past and show repeated patterns of non-payment, utility providers, insurance companies, even assisted living facilities can either refuse service or require major down payments from you.
Bottom line; bad credit severely limits you in life and causes both financial and emotional stress you don’t need.
Learning how credit scores work, and what creditors look for when making lending decisions is critical to raise credit scores and develop financially healthy habits.
