August 25, 2015

Credit Scores – Everything You Need To Know

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

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.

Individual credit scores are based on the following:

  • 35% Payment History
  • 30% Total Debt
  • 15% Length of Credit History
  • 10% New Credit
  • 10% Type of Credit

Contributing Factors

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.

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.

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.

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.

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.

Credit Score Range

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.  Credit score ranges are as follows:

Poor Credit Score- 500 to 559

Poor Credit Score- 560 to 619

Fair Credit Score- 620 to 659

Good Credit Score– 660 to 699

Very Good Credit Score- 700 to 759 

Excellent or Best Credit Score- 760 to 850

Credit Cards to Improve Credit Score Quickly

There are a number of credit card options that consumers can explore when either, establishing new credit for the first time or rebuilding credit history after foreclosure, bankruptcy, or other life events that lower credit scores.

Secured Credit Cards. These cards are often tied to a checking or savings account or require the user to put up a deposit before using the account. These make purchasing merchandise or services through MasterCard and Visa possible. A secured credit card is only helpful in improving credit scores if the lending agency reports payment history to the credit bureaus.

Retail Credit Cards. These cards often require little or no credit history to qualify for use, but may charge annual fees or high interest rates.

Unsecured Credit Cards for Bad Credit. Unsecured credit cards offer the convenience of major credit card use without a deposit or checking account. They are however, intended for consumers with lower than average credit scores or people establishing credit for the first time. Interest rates tend to be very high, 20-30% in some cases, to offset the losses incurred for non-payment to the credit company. Often consumers who establish a positive payment history with an individual lender using an unsecured bad credit card can graduate to a low limit unsecured card with better, more competitive rates.

Learning how credit scores work, and what creditors use to determine whether or not to lend money to consumers is necessary to begin to make the kind of changes involved in improving credit scores. While many different factors affect the overall end result of a credit decision made by lenders, by focusing on the five basic areas considered in the decision making process, you can work to raise credit scores over a period of time.