A credit score can be defined as a statistical three-digit number that is calculated by your credit history to determine your likelihood of repaying the debt by lenders. It is mostly used by a financial institution to evaluate a person’s credit risk objectively. Credit scores range between 300 and 850. There two most reliable and popular credit scoring models are the FICO scoring model and the VantageScore model. Both FICO and VantageScore model look at familiar data such as repayment pattern reports, credit card activity, bank account statements, etc. to calculate the score. Other credit scoring models include Experian’ National Equivalency Score, TransRisk, Insurance score, and CE Credit Score.
Note: America’s average FICO credit score and VantageScore in 2019 are 706 and 682 respectively. America’s FICO average credit score falls under the good score range while the VantageScore was in the fair credit core range in 2019. Compared to 2018, America’s average credit score increased.
The higher your credit score, the better for you because your credit risk is low.
Why does your credit score matter?
In a scenario where two consumers in need of a loan, the consumer with the credit score closer to 850 will attract a great monthly rate of interest rates of up to 5%. While the customer with a rate of closer to 600 gets even a 20 % monthly interest rate. Apart from affecting your loan interest rates and chances of getting a loan, your credit score also impacts other aspects of your life. For instance, when applying for a job, your employer’s decision to onboard you or not may significantly rely on your credit score. Therefore, we should pay close attention to credit scores to make life easier.
How do you calculate your score?
There are five factors that most impact your credit score. They include:
- Payment history
Your payment history accounts for 35% of your credit score. To ensure you excel in this category, you need to make all your payments on time and avoid negative public records such as foreclosure, liens, lawsuits, and bankruptcy.
- Credit History
Credit history is the duration of time you have owned a credit card. Credit history accounts for 15% of your credit score. The longer you own a credit card, the better for you. It is good practice to maintain one credit card for a long time. You should try to take up only the credit cards that you can pay off every month.
- Credit Utilization
Credit utilization is the ratio of your outstanding credit card balances to your credit card limits. In other words, it’s the measure of the amount of available credit you are using. Credit utilization accounts for 30% of your credit score. You should not spend close to your credit limit, even if you are never late on payments. You need to spend 30% or less of the available credit to do well n this category.
- Type of credit
A credit score model would want to know how many forms of credit you have, e.g. auto, mortgage, credit cards, etc. and how you pay them off. Credit use accounts for 10% of your credit score. It is a good thing to have a variety of loans and credit cards on your credit report. However, some practices such as applying for too much credit over a short period may raise a red flag for the credit bureaus. A desperate borrower is a risky borrower.
- New credit
New credit accounts for 10% of your credit score. Applying for is a credit card is okay, but the frequency and duration between the applications are important. If a consumer applies for more than two credit cards, it may indicate that you are using one to pay off the others. To perform well in this category, you need to spread your credit applications out over time.
Issues with Credit Scoring Models
The companies that develop scoring models keep a database of all the results securely. Such information is very valuable and dangerous if it got to the wrong hands. Information easily deducible from your credit score details include the following:
- Negative public records listed on your credit reports such as collections, bankruptcies, foreclosures and missing payments
- Your current residence and how long you have lived there. You can also tell whether the consumer owns or rents the residence
- Your occupation and how long you have worked there.
- Your complete credit history is in the bureau’s database.
- Your age
Benefits of Credit Scores
Speed – Credit scoring models have made it possible for a lender to evaluate thousands of credit applications thoroughly and swiftly. The customer enjoys how fast decisions on loans can be handled in less than a day.
Accuracy – The credit score system reduces human error when making decisions on a loan application. Lenders specify factors they want to be considered in the credit decision process. The lender knows almost immediately the kind of customer they are dealing with; whether low-risk or high-risk.
Unbiased – Credit scores help lenders to evaluate a customer’s creditworthiness objectively. A deserving consumer will most likely access the personal loan.
Incentive – The consumer can either improve or reduce their credit score. An improved credit score is a reward for timely and responsible payment of debts. Good credit scores serve as an incentive to practice good financial decision making.
How to Improve your Credit Score
There are a few ways you can alter your credit report to improve your credit score.
- Pay off all your bills on time. Once you start paying all your bills on time, you should see a significant difference in your score after 4 to 6 months.
- Increase your credit line. Call your credit card companies and ask for a credit increase. If you qualify for the raise, do not spend all of it. This is because you also need to keep your card utilization rate low.
- Restrain from closing a credit card account. It is better to stop using the card than closing the account.