Basics of Credit Scores
A credit score is essentially a number, a very important one at that. This number represents your financial history, taking into account a number of criteria and running them through sophisticated statistical tools. A credit score basically summarizes all the information in your credit report to a single number. Before a financial institution grants you credit, it will want to determine how likely you are to pay back a loan or how much financial capability you have to take the loan in the first place. A single glance at a credit score can give them a very good idea about this information. As you can tell, maintaining a good credit score extremely important if you are even remotely planning to take out a loan or buy something on credit.
How Is My Credit Score Calculated?
A complex formula, which represents a number of statistical procedures, is employed to calculate your credit score. Knowing the mathematical technicalities of that formula is not necessary but it would do you good to know how different aspects of your financial status factor into this formula and how much weight they have. The single largest component of credit score formula is your payment history. It is assigned a weight of 35%. Payment history takes into account your previous loan repayments, whether or not they were on time and how long you took to repay the loan. Defaulting on loans and filing for bankruptcy adversely impact this segment of your credit score. Outstanding debt, or amounts owed, account for 30% of the credit score formula. The higher this amount is, the less credit you are likely to receive. The amount of new credit you have taken and the types of credit used account for 10% each. The remaining 15% is assigned to the length of your credit history. This component helps financial institutions gauge how seriously they should take your credit score when determining your credit worthiness. A longer length implies more data and, hence, a more accurate representation. A shorter credit history length can at times be unreliable and financial institutions will take this into account. All this information is calculated and compiled into a single number ranging from 300 to 850.
How Is My Credit Score Used By Financial Institution?
Now that you have a rough idea about how your credit score is calculated, the next step is to learn about how financial institutions use this information to determine your credit worthiness. A score of 700 or above is considered excellent. Scores between 500 and 699 are considered average. Scores below 499 are considered sub-par. The first thing a financial institution uses your credit score for is to determine whether you are eligible for a loan in the first place. A credit score that is substantially below 499 is likely to disqualify you for any form of credit. If your scores are between 500 and 699, the financial institution will probe deeper into your credit report to get a better idea. Scores of above 700 almost instantly guarantee you a loan. Once your loan has been approved, the credit scores are then taken into account to determine the amount of interest you will be asked to pay. Once again, a lower score means higher interest and a higher score means lower interest. The exact amount of interest varies from product to product but the difference between the interest awarded to a person with a high credit score and the interest awarded to a person with a low credit score can be as much as 4%! Your monthly installment limit and the length of the loan period are also based on your credit score. Simply put, a good credit score ensures that you get a good deal when you shop for a loan. A bad one, however, puts you at the shorter end of the stick and gives financial institutions considerable leverage when hammering out the technicalities of the loan, if you are granted one in the first place.