What are Some of the Basics of Credit Score
To receive an accurate credit score that accurately reflects your creditworthiness, your credit history, and the current state of your credit, it is necessary to understand several topics relating to how and why credit scoring is done, along with the different aspects of the score. An important principle that is overlooked in most people’s understanding of credit scoring is that it is not an actual report card for your creditworthiness, but an evaluation of creditworthiness in regards to different aspects.
Understanding how a credit score is calculated will greatly assist you in understanding how credit is important to your everyday life. It is also important to realize that a credit score is not a great predictor of your creditworthiness because different credit scores are more accurate depending on the exact circumstances surrounding your credit. Understanding some of the basics of credit score can help you understand the general process of applying for credit and how important it is to be aware of your credit history.
What Is a Credit Score?
A credit score is an estimate of your creditworthiness. You will receive a credit score when a lender, lender, or credit agency such as one of the large credit card companies reviews your credit report and determines your creditworthiness.
At first, there may seem to be no difference between a credit score and a credit report. However, a credit report is a completely different entity. It does not analyze your credit history in the same way a credit score does. The difference between a credit score and a credit report is important to understand.
Why Do Lenders Use Credit Scores?
When a lender examines your credit report, it looks to see if you have a history of making payments on your loans and other financial obligations. A credit report, on the other hand, looks to see if you can pay your debts on time. A credit score, by nature, is more objective. The creditor uses your credit history as well as the amount of debt that you have to make a judgment about your creditworthiness. Therefore, the goal of a lender is to come up with a score that accurately reflects your creditworthiness in a way that doesn’t unfairly penalize you for a mistake in your credit history.
For example, a lender may have a problem with someone who pays their bills late but then fails to repay the loan. The reason this is problematic is that the amount of interest that you pay on a loan based on the amount of time that it is in arrears will likely be higher than the amount that you would pay if the loan was paid on time. Therefore, lenders want to come up with a score that takes into account the fact that you may not pay your bills on time, but that the amount of your debt relative to your income is much more representative of your overall creditworthiness than the number of late payments that you make.
What are the Five Components of the Credit Scoring Model?
The credit scoring model consists of five main components:
- Account history
- Credit utilization
- Payment history
- Length of credit history
- Credit mix
Understanding these components is important because the higher the percentage of each is in your credit history, the higher your score will be. However, it is important to know that simply having a credit history and a high credit score does not mean you can acquire credit. If you have been turned down for credit in the past, it can be difficult to get approved for credit in the future.
A strategy to successfully increase your credit score
As you can see, there are many things to consider when improving your credit score. This article has provided an overview of how credit scoring works and provides advice on what you can do to improve your credit score. If you want more detailed advice, read our tips on how to improve your credit score.
Credit Score Example
Using the example provided, a credit score of 800 would mean that you have an overall good credit history and high credit utilization. It is important to mention that any credit score will not be a perfect representation of your credit worthiness, as there is a wide variation of factors involved.
Not all of your credit score components will be relevant for all credit-related decisions. Some indicators, such as the length of credit history, are useful in calculating credit scores but do not necessarily reflect credit worthiness.
Additional Information on Credit Score
With the concept of credit scoring explained, it is now important to understand how credit scoring works. To have an accurate credit score, it is necessary to have an accurate credit history and high credit utilization. If a customer has a low credit score, this will impact on their ability to obtain credit. In this section, we will give a summary of the major components and their impact on credit scores.
Credit History
Credit history is the total amount of debt owed in your name. This type of credit score is measured against total credit card debt, or other secured loans such as home loans, car loans, and other loans. If you have a large balance of secured loans, such as a car loan, the secured loans are assessed as a much larger amount of credit. To calculate your credit score, both secured loans and other consumer debts are included. When calculating a credit score, credit utilization is also considered.
This is a portion of credit limits that have been used. If you do not have a high credit limit, your total credit limit could be low. A small portion of your total credit limit will appear as a credit utilization when calculating your credit score. In our example, our credit score is 800. Our credit utilization of debts to income ratio is 75%, meaning that 75% of our total credit limits have been used. Because of the small balance of our credit lines, our total debt is 75% of 800.
This causes our credit utilization to be at 25%, which will reduce the amount of credit history a customer has, and therefore reduce their overall credit score.
Credit Utilization
The final component is credit utilization. Credit utilization is the percentage of total credit limits which are used, as a percentage of their total credit limit. As stated earlier, there is a huge range of different factors that can affect the amount of credit available to an individual, and credit utilization can be influenced by many of these factors. Understanding the different factors that can affect the amount of credit an individual has, is a key factor in calculating their credit score.
Credit utilization is the fraction of total credit available to repay an individual, which is likely to be paid in full. This shows the amount of time that a credit card or home loan is likely to be used before default. A credit score is calculated by comparing the credit utilization to the maximum credit available.
Credit Score
The credit score is a measure of a consumer’s creditworthiness and is part of the FICO credit scoring system. There is a wide range of credit score components to consider when assessing your creditworthiness, but this is a summary of the main components. When calculating a credit score, it is necessary to consider total debt in addition to other debt, and the credit utilization of different debt types.
Total Credit History
When considering total credit history, credit history is determined by accounts opened or operated on different cards. Allowing credit cards to finance other types of debt, such as mortgages, also adds to total credit history. Therefore, by using multiple credit cards, or taking out credit home loans, one can create a higher level of total credit history.
Credit Line
Different types of credit limits are available for an individual. A personal loan, such as a mortgage, can often be used to increase the total credit limit an individual has. Because a mortgage is a secured loan, the level of credit that the mortgage is used for is considered as a debt limit to calculate your credit score. When calculating a credit score, the credit limit is included in the total credit history.
Interest Rate
The interest rate is calculated by dividing the amount of interest expected on a loan by the total amount borrowed. For example, if a credit card has a balance of $10,000 and a $5,000 credit limit, and the interest rate is 5% per year, the average monthly balance is $400, and the annual interest rate is $10 per month. A credit score is calculated by dividing the total credit history and total debt and then adding the total of the two, to get the final score.
Credit Score Example
Credit Score = Total Debt + Total Credit History
Total Debt = $800 x 25% = $300,000
Total Credit History = $1,500 x 75% = $750,000
Total Debt/ Total Credit History = 80%
Total Credit History = $750,000 + $750,000/400 = $7,500,000
Total Debt/ $7,500,000 = 6%
Therefore, your credit score is a direct measure of the balance that you carry and is directly affected by the cost of credit.
The Negative factors that can affect the credit score are:
- Loans/Credit Cards that are overdue
- Payments on credit cards
- High delinquency rate
- Credit limitations
Credit limits
A limit is the amount of credit that an individual is permitted to apply for. It is important to know how much credit an individual is using before applying for a loan because it is possible to appear to be “credit disciplined” by having a high credit limit, but it is possible to pay off the credit limit as quickly as possible, and not use the credit line.
As the credit limit is not designed to provide a long-term credit line, the balance left over after any use is not counted as part of the total amount that can be applied for. Depending on the loan application, the lender may accept the late payment from the previous month and extend the credit line for another month.
The lender then has the option to grant the original request of the initial loan or to extend the application for another month. This is why when applying for a personal loan, one must make sure that the funds are applied towards paying off the debt.
Also, the applicant must submit monthly statements showing the amount of money that is being deducted from the loan, as well as how much is being spent every month. At the end of the loan, the lender will assess the credit line to ensure that the applicant is continuing to repay the debt.
After all, is said and done, it is important to remember that a credit score is a number that shows the “bottom line” of a person’s credit history. The credit score will, more often than not, reflect what the individual has done, and what their character and actions are in the future.
For example, a lot of people who want to apply for a home loan will decide to get a personal loan or a credit card. Their credit score will be better because of the personal loan or credit card application.
The personal loan or credit card application shows the lowest possible credit available, or a low credit limit, which the individual is willing to accept. The maximum credit line for the personal loan or credit card application shows that the applicant has a higher limit of credit available to them.
A higher credit limit means that the applicant is more likely to be approved for the loan or credit card. In some cases, and if the credit limit is not that high, the credit limit might be lowered by the lender. One might consider the different effects of reducing a person’s credit line on their credit score.
In other words, if the credit limit is reduced from $10,000 to $1,000, the credit line will be reduced from 20% to 10%, thus making the overall average higher than it would be without the lower limit.
Conclusion
Ultimately, the goal of any credit reporting agency is to provide information to financial institutions and potential lenders. The reason that credit scores are provided is that lenders base a person’s credit score on a variety of factors. Credit scores are a tool that financial institutions use to make decisions about loans.
