By MoneyWise Staff
Wednesday, September 2, 2020
Many people do not monitor their credit or know much about the credit scoring system until they attempt to make a big purchase. Buying a home or starting a business can require a large amount of money and often a loan. Each individual has a credit score. This is a three digit number that lenders use to determine how likely it is that an individual will pay back the loaned amount. A person’s credit score is also used by the lender to determine the interest rate. To the lender, a credit score is like a report card reflecting a person’s success of being financially responsible.
If you are married you and your spouse each have your own credit score. If you co-sign on a large purchase together, both individual’s score will be checked. Credit scores range from approximately 300 to 850. The lower the credit score the riskier it is for a lender to loan money, and it’s less likely the lender will grant the loan. If a loan is approved on a lower credit score, the loan will cost more overall. When it comes to locking in an interest rate, the higher the score, the better your terms of credit will likely be.
To obtain your own credit score you can request your score (for a small fee) and your credit report (for free) from annualcreditreport.com. Many credit card suppliers will provide you a free estimate of your credit score as a benefit. A credit report shows details about the lines of credit that you have established or have had within the past few years. A credit report is available for you to request without charge, once a year, from each of the three main credit bureaus. So you can monitor your credit on a regular basis if you space your request out obtaining one report each quarter of the year.
The most well-known credit scoring system was developed by Fair Isaac Corporation and is called the FICO score. The three major credit bureaus, Equifax, TransUnion and Experian, use the FICO scoring model for their proprietary systems. Since each scoring system uses a slightly different statistical model, your score from each of the three will not be exactly the same. This is because lenders and other businesses report information to the credit reporting agencies in different ways, and the agencies may present that information through their proprietary systems differently. Because different lenders have different criteria for making a loan, where you stand depends on which credit bureau your lender turns to for credit scores.
Composition of a Credit Score
Each individual’s credit score is determined by taking five components into account. Below is a chart of the components and the corresponding percentage of how much each component affects the overall credit score.
|How much you owe||30%|
|Length of credit history||15%|
|Type of credit||10%|
|New credit (inquiries)||10%|
Payment History pertains to an individual’s track record of paying back debts on time. This component encompasses payments on credit cards, retail accounts, installment loans (such as automobile or student loans), finance company accounts and mortgages. Public records and reports detailing such items as bankruptcies, foreclosures, suits, liens, judgments and wage attachments also are considered. A history of prompt payments of at least the minimum amount due helps your score. Late or missed payments hurt your score.
Amounts Owed or Credit Utilization reveals how deeply in debt you are and contributes to determining if you can handle what you owe. If you have high outstanding balances or are nearly "maxed out" on your credit cards, your credit score will be negatively impacted. A good rule of thumb is not to exceed 30% of the credit limit on a credit card. Paying down an installment loan is looked upon with favor. For example, if you borrowed $20,000 to buy a car and have paid back $5,000 of it on time, even though you still owe a considerable amount on the original loan, your payment pattern to date demonstrates responsible debt management, which favorably affects your credit score.
Length of Credit History refers to how long you have had and used credit. The longer your history of responsible credit management, the better your score will be because lenders have a better opportunity to see your repayment pattern. If you have paid on time, every time, then you will look particularly good in this area.
Type of Credit refers to the "mix" of credit you access, including credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. You do not have to have each type of account. Instead, this factor considers the various types of credit you have and whether you use that credit appropriately. For example, using a credit card to purchase a boat could hurt your score.
New Credit (Inquiries) suggests that you have or are about to take on more debt. Opening many credit accounts in a short amount of time can be riskier, especially for people who do not have a long-established credit history. Each time you apply for a new line of credit, that application counts as an inquiry or a "hard" hit. When you rate shop for a mortgage or a car loan, there may be multiple inquiries. However, because you are looking for only one loan, inquiries of this sort in any 14-day period count as a single hard hit. By contrast, applying for numerous credit cards in a short period of time will count as multiple hard hits and potentially lower your score. "Soft" hits—including your personal request for your credit report, requests from lenders to make you "pre-approved" credit offers and those coming from employers -will not affect your score.
Good credit management leads to higher credit scores, which in turn lowers your cost to borrow. Living within your means, using debt wisely and paying all bills on time, every time are smart financial moves. These lifestyle choices help improve your credit score, reduce the amount you pay when you need to borrow and put more money in your pocket to save and invest.
Some information in this article was extracted from a FINRA publication.
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