You often times hear on television commercials and financial news shows about this all important credit score. A credit score is a very important number that is associated with an individual. When you apply for a loan, the lender will check your credit score with one of three major credit reporting agencies, Experian, TransUnion, and Equifax.
The check will return a number and that number reflects the creditworthiness of the loan applicant. In other words, a credit score shows the likelihood that the person wanting to borrow money will in fact pay it back per the terms of the agreement. Many don’t know what goes into computing this score so here’s a synopsis of what is involved.
How is a Credit Score Computed?
There are different types of credit scores but the most widely-used is known as the FICO score. FICO is the acronym used to refer to the Fair Isaac Corporation. There are several variables that go into computing your FICO credit score. These variables include payment history, level of debt, number of inquiries, credit history length and types of credit.
Since businesses are concerned about having a steady cash flow, payment history weighs significantly in computing a credit score. In fact, it is given a weight of around 35%. This variable reflects how reliable you are in paying your bills. Late payments are taken into consideration and recent payment history has a greater affect than older history.
The level of debt variable reflects how much you owe in relation to how much credit you have available. Since there is no way of accurately knowing your income, it doesn’t come into the picture. When this ratio increases, you credit score is lower. Recommendations are to never let this ratio go above 30%.
A credit inquiry is done each time you are applying for a loan. If the frequency of credit inquiries on your behalf is high, it means that you are looking to take on more credit or you are having trouble with your finances. Only inquiries within the last year are used.
A lengthy credit history gives an indication about how you spend. Therefore, your credit score benefits by having a longer history. This is one reason why you should not close credit card accounts that you have paid off. It is also one of the reasons why those starting out don’t have any credit and that is because there is no history.
Having a credit mix of different types of loans (auto, credit card, and home mortgage) gives an indication of how well you manage your debt if other variables are favorable such as a low debt ratio.
What Does The Score Mean?
After taking all the previous variables into consideration, a number is returned for a credit score. This will usually be in the range of 0 to 850 with the majority between 600 and 700. If you have a credit score above 700 then you are considered to be an excellent credit risk and will probably get a loan at a very low interest rate.
On the other hand, if you have a score below 350 you can pretty much come to the conclusion that you will not get your application for credit approved. Most people tend to hover in the middle and will get credit at average or above average interest rates.