By Aniket Bose. Edited by Arjun Chandrasekar.
A credit score is a number that ranges from 300-850 which depicts a consumer’s creditworthiness. The higher the score, the better a borrower is viewed by potential lenders. A credit score is based on a consumer’s credit history: number of accounts, the total amount of debt, history of paying the money back, and other factors. Lenders can use credit scores to evaluate the probability that an individual will repay their loan payments on time. The credit score model was designed by the Fair Isaac Corporation (FICO) and it is used by multiple financial institutions. There are many ways that a person can improve their credit score, including repaying loan payments on time and keeping their amount of debt low.
How do Credit Scores Work?
A credit score can have a meaningful impact on an individual’s financial life. It plays a major role in the decision-making of a lender to offer individual credit. People that have credit scores below 640 are typically considered as “subprime borrowers”. Financial institutions often charge higher interest rates to subprime borrowers rather than a conventional mortgage as a method to compensate themselves for dealing with a lot more risk. They may also require a shorter repaying term or having co-signers as borrowers for lower risk. Credit scores of 700 or above are generally considered good and can result in a borrower receiving a lower interest rate when they apply for a loan. This also results in them having to pay less money in interest over the timespan of the loan. Credit scores that are over 800 are considered excellent and they receive the best interest rates when they are borrowing money through loans.
A person’s credit score may also determine the size of an initial deposit that is required for them to obtain regular products such as a smartphone, cable services, renting an apartment, etc. Lenders have to frequently review the credit scores of borrowers, especially when they are deciding to charge an interest rate or a credit limit on a credit card. There are three major credit reporting agencies in the U.S.: Experian, Equifax, and Transunion, which report, update, and store the credit histories of consumers. The five main factors that are evaluated by these three major credit reporting agencies when calculating a credit score are payment history, total amount owed, length of credit history, types of credit, and new credit.
The payment history of an individual’s accounts for 35% of a credit score and shows financial institutions whether the individual pays their bills and payments on time. The total amount owed of an individual’s accounts for 30% of a credit score and for the percentage of credit available to a person that is currently being used, which is called credit utilization. The length of credit history accounts for 15% of an individual’s credit score as people with longer credit history are considered to be less risky for financial institutions since there is a lot more data and information to determine their payment history. The type of credit accounts for 10% of an individual’s credit score and shows institutions if an individual has a mix instalment credit, such as car loans or mortgage loans and credit cards. New credit also accounts for 10% of an individual’s credit score and it factors in how many new accounts an individual has, how many new accounts they applied for recently, resulting in credit inquiries, and when their most recent account was opened.
An individual’s credit score is one number that can either cost or save an individual a lot of money in their lifetime. It is beneficial to have an excellent credit score because it can land you lower interest rates when you apply for loans, which means you will be able to pay less for any line of credit that you take out when you apply for a loan. The decision is up to you as a “borrower” to maintain a strong and good credit score so that you can have access to more and new opportunities to borrow money if you need to!