What is a Credit Score (and Why You Should Care)
by Lisa Adams
Credit scoring systems are utilized by creditors to determine if borrowers are a good risk for credit requests. Data is analyzed from the credit application and the credit report evaluating items such as: bill-paying history, the number and type of accounts opened, late payments, collection actions, outstanding debt and the age of the accounts. It reviews all applicants objectively by comparing the borrowers’ credit information to the credit performance of consumers with similar profiles. The credit score is a three-digit number used by financial institutions to assist in loan decisions. This score predicts the likelihood that a borrower will repay the loan and whether they will make the payment on time. Before the prevalent use of credit scoring, a financial institution could make only a personal interpretation of how likely a borrower was to repay a loan as agreed. Personal judgment would influence whether or not a person would be approved for a loan. The accessibility of credit scoring has drastically changed these methods.
Credit scores range between 300 and 900. There are three major credit bureaus that report these scores: Equifax, Experian and TransUnion. Each credit bureau has its own unique system. However, the scoring models have been standardized so that a numerical score at one bureau is the equivalent of the same numerical score at another. Thus, a score of 700 from Equifax indicates the same creditworthiness as a score of 700 from TransUnion or Experian, even though the calculations used to determine those scores differ. C redit bureaus calculate a credit score each time a credit bureau is requested by a lender, and is based on the current information in the credit file. For example the higher the credit score, the lower the perceived credit risk is in lending to this borrower. A credit score does not evaluate a person’s behavior or any personality traits; it simply gives a lender a snap shot of the risk involved in granting credit.
Credit scores affect all areas of a borrower’s financial life, and it is important to understand the basis of these scores. The law prohibits credit scores from taking into consideration ethnicity, religion, gender, marital status or nationality. Credit scores are driven by both positive and negative information in a credit report. Approximately 35% of the credit score is based on payment history. In order to make an unbiased decision, a lender must know how the borrower has paid past credit obligations. About 30% of the score is based on the amount of debt owed. Owing a great deal of money on numerous accounts can indicate that a person is overextended. Typically, a longer credit history will increase the score. This is important to note because 15% of the score is based length of credit. Opening several credit accounts in a short period of time can impact a score, which accounts for approximately 10% of the credit score. The final 10% is based on a combination of credit cards and installment loans. While a healthy mix will improve your score, it is not necessary to have one of each, and it is not a good idea to open credit accounts you do not intend to use. The credit mix generally will not be a key factor in determining your score; nevertheless, it is more important if your credit report does not have a vast amount of information from which to base a score.
In general, a credit score of 700 and greater is considered “good credit”. Borrowers with these scores receive the lowest interest rates. The lower the credit score, the higher the interest rate a borrower may pay. For example, two separate borrowers wish to purchase a $15,000 auto loan for a 60-month term. One has a credit score of 700 and the other a credit score of 620. These are different scores, which result in a different credit risk for the lender. The borrower with the 700 credit score receives a much lower interest rate, which results in a low payment of $290.00 per month. The borrower with the 620 credit score receives a higher interest rate, which results in a higher payment of $334.00. Over the life of this loan the 620 borrower will pay over $2,500 more in interest than the borrower with the score of 700.
Your credit history can affect your daily life. Being knowledgeable of how your pay habits reflect your credit score allows you to better control your finances. The better your credit history and credit score, the better your chances of obtaining a low-cost loan, an insurance policy, renting an apartment, or even qualifying for a job. Paying on time is the most important thing you can do to keep a higher credit score.
Remember, a credit score is only as accurate as the information contained in your credit report, so be sure to request a copy of your credit report each year from the three major credit reporting agencies. I hope this information will help you establish, re-establish, or continue on your path of good credit history.