Understanding Credit Scores
It is important to understand how credit scores work because this number is part of what determines whether you will be approved loan, a credit card or finance plan, and how low the interest rate will be. Since your good credit score is a major factor when getting credit, it helps to know and understand all of the different aspects of your credit score.
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What Is A Good Credit Score Rating?
It is a predictive measurement of an individual borrower's credit stability. This number gives lending institutions a consistent and objective way to evaluate whether or not to extend credit. The credit scoring system evaluates the patterns of hundreds of thousands of past credit reports to identify common variables, such as the probability of a person defaulting on a loan, or becoming over-extended. By identifying consistent variables based on past credit history, the system can then predict future credit behavior.
Elements that determine how good your credit score is Using a mathematical formula, your credit score takes into consideration your credit history, how you've paid your bills, how much open credit you have, as well as other factors that predict your credit worthiness. The formula then compares your information to the credit performance of other consumers with similar profiles to produce a three-digit number. Lenders use this three-digit number to determine whether or not to lend money, how much money to lend, and what interest rate will be charged.
How many credit scoring systems are there? Your credit score may be different from lender to lender, depending on the credit scoring system that was used. Credit scoring systems all look at the details in your credit report. However, the systems look at the information slightly differently depending on what the score is being measured for, and where the comparative information is coming from. Below is a brief overview of the four main credit scoring systems.
Who Can Check My Credit Score?
If you've wondered that, you are not alone. What is disturbing to a lot of people is how many different industries use credit scores to make business decisions. For years, creditors have used credit-scoring systems to determine whether individuals are a good risk for mortgages, credit cards, and loans. But, did you know that other businesses also check your credit score when deciding to work with you or not?
The use of credit scores has grown over the years because it gives businesses an objective way to measure the credit risk of potential clients. Generally, the higher a person’s credit score is, the more likely they are to meet their financial obligations. This means less risk for the business.
Which businesses can check my credit score? Businesses or individuals with a "legitimate business purpose" can access your credit report and score to determine whether to do business with you or not. Below are some of the various types of businesses that commonly access credit scores:
Why do lenders see different credit scores? Because credit scores can be accessed through various companies, credit scores may differ depending on which credit bureau calculated the score. Also, some companies base their decisions on only one credit score, while others will look at all three credit scores.
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Elements That Determine Your Credit Score
When it comes to computing credit scores, you need to understand that there are 5 elements that determine how good your credit score is. These elements come from the information in your credit report, and points are awarded for each factor. The total points predicts how likely you are to repay your debts in a timely manner, which is a powerful indicator of credit-worthiness to lenders. The total amount of points that you can have on your credit score can range from 300 to 850, depending on the source.
Now let's take a look at the 5 elements that determine your credit score and how points are calculated. The most important factor in computing your credit score is your payment history, followed by amounts owed, length of credit, types of credit, and finally new credit accounts. You can find a more detailed description of each of these factors below:
Payment History determines 35% of your credit score, with the most emphasis given to recent activity. Your payment history includes:
Currently, it's possible to have more than one score, depending on which credit bureau furnishes the information and the scoring system used. In March of 2006, the three main credit bureaus rolled out a system that strives to produce consistent credit scores, regardless of where they originated.
This new credit score system will be called the VantageScore, and should be available to consumers fairly soon. It is similar to many of the old scoring systems, with the range of credit scores falling between 501 and 990. What weight it gives to the 5 elements that determine credit scores is still unknown, but it will be based on a 24-month performance period. Even though it offers consistent scoring capabilities, the other credit scoring models will still be available to consumers.
How a Credit Card Affects Your Credit Score
Those shiny pieces of plastic can be the best thing in the world, or the worst, depending on your point of view. Use them without discipline, and you will very quickly find yourself in debt. Use them wisely, avoiding impulse buys and paying off your bills very month, and they are the greatest and most convenient things in the world. Even better, they will prove to the credit bureaus that you are a financially responsible person, and your credit score will go up and up. Let’s see how this happens.
Credit Cards – A Window into Your Financial Life Most credit reports begin life with a credit card. Whether you are a student or your bank introduced you to the wonderful world of credit, that very first application has been marked and compiled in a computer. Every month, another record will go on your new credit report, showing if you paid your bill on time, and how much you paid off. As you go through life, car loans, mortgages, bankruptcies and other financial and social information will be added to your report, newer items affecting your score more than older items.
Many financial actions comprise your credit score – your total debt load as a percentage of your total credit limit, the age of your credit history, the frequency you apply for new credit, and how well you pay your bills off. As you can see, credit cards can be a factor in all of these actions.
What a Credit Score is Made Of Total debt load (about 30% of your score) – Having lots of debt will not necessarily lower your credit score. It’s how much debt you have and how much credit you have available. For instance, if you have two thousand dollars on your credit card, it could look bad. However, if you have a ten thousand dollar limit, that’s only 20% - a very healthy ratio. Credit lines and mortgages versus the value of your house are also taken into account.
The age of your credit report (about 15%) – Lenders need to know how well you respond to paying your bills. In order to do that, they need to see how you have behaved in the past. Because credit cards will likely be your first introduction to credit, paying your bills on time, and consistently, will be a good indication of your reliability to handle money well.
Applying for new credit (about 10%) – It stands to reason that the more lines of credit you have, the lower your score will be. This is simply because you are carrying more debt. However, even if you are not approved, this application still counts. Applying for credit too often could be an indicator of financial irresponsibility, such as applying for too many credit cards in too short a time, or hopping from card to card.
Paying your bills (about 35%) – The largest factor in keeping your credit score in a good state is, of course, paying your bills. Skipping payments, only paying the minimum (thus carrying a higher debt load), or walking away from loans will immediately destroy your score. Conversely, paying on time, in a predictable and consistence manner, will prove to future lenders that you are financially trustworthy. Credit cards, or course, are a huge factor in this. Pay on time, as much as possible, and your score will be excellent.
Okay, I Pay My Bills on Time, But My Score is Still Low! If you are concerned with getting a better credit rating, there are a few factors to investigate. If you rule out past bad debt such as defaulted loans or a high debt load, take a look at how your credit card activity is reported. First, make sure your credit card company is actually stating your credit limit. If they are not, then your credit report will calculate your credit limit to be the highest amount you ever placed on your card. This will make it appear your debt load is too high, and your score will suffer.
Another option is that you may have cancelled one of your credit cards. As strange as this seems, this could have actually hurt your score! Why? Two things – if that card had a long credit history, this source is now gone. The second thing is that your overall credit limit is now lower. The credit bureaus calculate the credit limit of all your cards together, so removing one will remove that extra credit.
Instead, if you are trying to get your finances under control, cancel your store credit cards (they aren’t worth as much), and take one of your major cards out of your wallet and keep it in a safe place. Use it once or twice a month just to keep it active.
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Good Credit Score Stats and Ranges
Understanding credit score stats can help you put your own rating into perspective. The first thing you need to realize is that it is possible to have more than one score. Each reporting bureau calculates your score individually, and your number may vary due to differences in your credit history at each bureau. Also, while scores generally range from 300 to 850, there are slight variations in the range, depending on which agency is reporting the information. For example, here are the ranges for each bureau:
Credit Score Distribution
Among the General Population Based on the general population's FICO® scores (as stated by the Equifax website), the percentage of the population scoring in each range is as follows:
Interpreting Credit Scores
Given the current credit score stats, how does this relate to your own personal score? Generally, if your score is higher than 660, you will be considered a good credit risk. If your score is below 620, then you might have a tougher time getting a loan. The following ratings explain the impact of the different score ranges:
Credit Score Needed to Buy A House
It is not impossible to obtain a mortgage with an imperfect credit rating, and you may even be able to qualify with a score as low as 500. In fact, some lenders specialize in sub-prime loans (for scores below 620), even though it means higher down payments and interest rates for the borrower.
On the other end of the spectrum are scores over 720, which means a person has excellent credit and will probably receive the best financing terms. For scores in between 620 to 650, most people will qualify for financing, but will probably have higher fees and rates.
Because interest rates are determined in part by your score, it's important to know where you stand before you ever begin the loan process. MyFICO has a really neat application that lets you see the possible interest rates, based on your state, credit score, and loan amount. It also shows you how much you could save in interest based on improvements to your score.
While these credit score stats can give you can indication of what to expect, you need to understand that each lender has their own range of acceptable scores. Lenders also consider other factors, such as your employment, savings, and income-to-debt ratio when making decisions on whether to lend you money or not. Therefore, you should find out what your lender's requirements are before you apply for a loan.
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The Secrets of Raising Your Credit Score
Why is it important to learn the secrets of raising your credit score? Because your score helps determine whether you'll be able to get credit and the interest rate you'll qualify for. If you are planning on making any major purchases within the next few years (such as a home or car), you should start working on improving your credit score now.
Since credit scores fluctuate over time, the steps you take now will reflect positively in the future. Credit scores place the most emphasis on information that is reported within the last 24 months, so the actions you take now can really help. This means that even if you currently have a bad credit score, it won't haunt you forever if you work on improving it. Below are the main areas to work on when trying to build up your credit score.
Correct errors on your credit report One of the first places to begin improving your credit score is by checking your credit report for errors. This includes such things as accounts that don't belong to you, or paid accounts that are still showing a balance. Having inaccurate information removed from your credit file can really make a difference on your score, so it's worth the effort. To correct any errors, you will need to contact all three credit bureaus to dispute the information. You can find a more detailed description of correcting inaccurate information in our article on disputing credit report mistakes.
Build a Solid Payment History
Since your payment history accounts for 35% of your credit score, you need to make sure that all your accounts are up to date and don't show late payments. Pay off past due accounts, and then concentrate on paying your bills consistently before the due date. If you tend to forget to mail your payment in on time, consider automatic bill payment options (either through your bank or online).
You may be wondering how liens, judgments, collections, and bankruptcy will affect your credit score. I won't lie to you. These bad marks will seriously lower your credit score, but not indefinitely. Since this information may only be reported for 7 to 10 years, it will eventually drop off your record. And, if you can consistently pay your bills on time for two or three years, the impact of these negative items will not be as great.
Lower Your Debt Ratio
If you've extended your credit to the limit, it will have a negative effect on your credit score. By keeping your credit card balances low (less than 20% to 30% of the available credit), you'll not only be in better financial shape, but you'll also bring your score up.
It's common to carry a large balance on one card and have another card that you either don't use, or pay off in full every month. If you will be applying for a loan in the near future, you might consider transferring some of the balance to the other card to even out the percentage of available credit on each card.
The next thing that you want to concentrate on is paying off your existing balances. Try paying more than the minimum amount due on your accounts, and if possible, pay the balance in full. Once you pay off an account, don't close it because it will elevate your debt ratio due to the fact that you will have less available credit.
Another way to temporarily build up your credit score is to not use your credit cards for a few months before you apply for a loan. Because creditors provide a monthly statement to the credit bureaus (which may occur before your payment is received), your account may show a balance, even if your pay your statement in full every month. By paying with cash for a month or two before you apply for a loan, these accounts will show either a lower balance or no balance at all. The end result is that your debt ratio will be lower, which will move your score upwards.
Your Length of Credit History Matters If you've been thinking about closing those old cards that you don't use any more, don't do it until after you've qualified for a loan. Closing old accounts can lower your credit score it because it decreases the length of your credit history. You want to keep long-standing accounts open because it shows a longer history of established credit. If you are determined to close out accounts, make sure that you keep the oldest one open (it doesn't matter what the interest rate is if the balance is paid off).
If you don't currently have any credit accounts showing on your credit report, opening a low balance credit card can actually lift your credit score. Also, if your credit history is less than three years old, work on establishing a good payment history by paying your bills consistently on time.
Limit New Credit Accounts and Inquiries
Every time someone looks at your credit report, it shows up as an inquiry. There are two types of inquiries, soft and hard. If you order your credit report, it is counted as a soft inquiry, and won't affect your credit score. Other types of soft inquiries include inquiries for promotional offers (such as credit cards or insurance), account reviews by your current creditors, and internal inquiries by the credit bureaus.
Hard credit inquiries occur when you authorize a company to review your credit report. This happens when you apply for a bank loan, credit card, lease, or cell phone. Hard inquiries may also appear if the IRS is auditing you or if a collection agency is trying to collect a bad debt.
Hard inquiries deduct from your credit score, so you want to keep them to a minimum. If you will be shopping around for the best rate on a loan, do it within a short period of time. Inquiries made within a few days of each other will generally be counted as one inquiry.
Diversify the Types of Credit In Use
This area accounts for 10% of your credit score, and the different types of credit will affect your score differently. Having a credit card that you consistently pay on time (with a low balance) will help your score. Installment loans, such as a mortgage or car payment, can also help your rating if your payment record is good and you have paid the balance down. Cash loans and finance company credit may deduct from your score because it appears that you might be a high risk and can't qualify for mainstream financing. The best mix is to have one or two major bank credit cards and one or two installment loans.
How Long Does it Take to Build up your Credit Score?
This is not an easy question to answer because it depends on how you handle all aspects of your credit. Generally, there's not a lot of fluctuation during a short period because your score is mainly based on information reported within the last two years. By consistently paying your bills on time, you can see a difference in your score within 6 to 9 months.
But don't get discouraged. It is worth the effort to work on improving your credit score, because a few points can mean the difference between the best rates and a sub-prime loan. Therefore, try to have no late payments or derogatory items on your credit report for at least 12 months (preferably 24 months). Also work on paying down your outstanding balances and don't apply for new loans.
Following the secrets of raising your credit score will benefit you in many ways. Not only will your credit score reflect your efforts, your financial life will be much easier as a result, helping you qualify for the best credit, jobs, insurance, and more.
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