A lower credit score is something that can cause a lot of difficulty in matters pertaining to finance. Well, everyone wants the highest score due to some of its obvious advantages. The concept of credit score came into being, post the 1970s, when loans and credit cards started becoming popular. Therefore, a need to develop a system to assess creditworthiness was felt. The Fair Issac and Company, popularly called FICO, made a breakthrough in the field of credit rating or scoring.
What is a Credit Score?
When people like you and me apply for loans, the lender or the bank undertakes a procedure that is known as 'loan underwriting', where the risk, creditworthiness, and the probability of a loan or a credit card bill being defaulted is assessed. The lending party is basically assessing whether you will be able to pay off the required bill or not. A credit score is an important tool that helps them to assess this risk. Apart from that, the score also helps the lenders to determine a fair interest or APR rate.
A really bad credit score could mean that your application gets rejected or you will end up paying a high interest rate. Similarly, for an excellent score, the interest rate would be substantially lower.
FICO provides its mechanism for almost 90% of the credit reporting agencies. Even though the formulas and procedures are named differently from agency to agency, the basic constituents affecting credit score are the same. The three different models for credit scoring by FICO include BEACON score used by Equifax; Experian/Fair Isaac Risk Model used by Experian; and EMPIRICA used by TransUnion. The companies do not disclose the exact formulas but as per FICO resources, the pointers as described below, make up a credit score.
- Payment History (35%): The payment history basically consists of all your past accounts and the regularity with which payments have been made. A bad and irregular payment history causes the score to drop down.
- Amounts Owed (30%): The total amount of debts owed currently is also an important consideration in the score calculation. The standard equation is, more the amounts owed, less is the credit score. Hence, keep the current liabilities to a bare minimum.
- Length of Credit History (15%): The length of the credit history is also considered. The thumb rule is that longer the history, lesser is the score. Thus, avoid unnecessary borrowings and keep them to a bare minimum.
- New Credit (10%): New credit consists of the recently borrowed loans or credit cards. Keeping it small always helps, as lesser the new credit, better is the credit score.
- Types of Credit Used (10%): Types of credit such as credit cards, types of loans, and other credits such as 'buy now, pay later', are also considered.
This proportion is applied to get a number on the credit core rating sale, which usually extends from 300 to 850. This credit rating scale may differ as per the company and FICO program.
Apart from these constituent factors, other incidents also tend to have an impact on the credit score. We will look at some of them as described below:
The credit score will drop based upon the number of debts that went bad or were not repaid. The exact amount differs from case to case. You will also have the bankruptcy record on the credit report for some years and will have to abstain from borrowing for a court-mandated time frame.
Foreclosure affects the score in a similar manner as bankruptcy. The score decreases in proportion to the losses borne by the lender.
Loan modification may or may not affect the score and will depend upon the losses suffered by the lender. The score will vary as your credit history and current liabilities change.
Closing a credit card
Closing a credit card does not affect the credit score, only if you do not leave any pending dues with the bank. Unpaid debt adds to the credit history and the total amount owed.
What affects your credit score the most?
Quite simply, your spending. It is recommended that you follow certain principles - a) Do not borrow when not needed and do not spend when not needed. b) Never make a late payment and set aside a provision for your credit card bill and loan installments, the moment you get your paycheck. c) Avoid credit cards as far as possible, since you are paying interest, which is a waste of money.
On the whole, managing personal finances properly and curbing unnecessary expenditures proves to be an excellent strategy for maintaining a good credit score.