Credit score - What it is, components, important facts to know

Do you know that whenever you apply for a loan, the creditors assess your creditworthiness through your credit score? If you have a good score, then you can take out a loan at your favorable terms and conditions. So, you should try to have a clean credit record so that you have a good score.

Your credit score helps the lenders with an authentic assessment of your credit risk. It is basically a number used by the lenders to decide as to what are the chances of retrieving their credits back from you on time. The credit reporting agencies maintain credit reports. These reports give information based on which the credit bureau scores are assigned.

It is your right to know what credit scoring agencies have to say about you. Finding out this information doesn't cost a lot and takes only a few minutes.

Developed in 1970, the Fair Isaac Corporation introduced a method to measure the ‘creditworthiness’ of an individual. The system was first developed in the 1950s, but has come into widespread use in just the last couple of decades. It is a method of assessing the credit risk of a loan applicant. It uses mathematical models to evaluate a person's creditworthiness based on his/her credit history and current credit accounts. The FICO formula and scoring model remains a closely guarded secret to this day.

Currently, there are 5 different types of credit score formulas (including the FICO formula) in circulation, each with varying characteristics. This has caused much confusion within the consumer community.

The FICO score

This is the most widely adopted credit score and scoring model in the industry. The Fair Isaac Corporation is the father of the FICO score and is the originator of the credit report concept. Credit reports are generated by the three leading credit reporting agencies (CRA), namely, Experian, TransUnion, and Equifax. Since every creditor doesn’t report to all of the 3 credit reporting agencies, FICO scores generally happen to vary from one CRA to another. Sometimes, the score point deviation can be as much as by 80 points. The FICO score scale runs from 300 to 850 points.

The PLUS score

PLUS is an acronym for Plan, Live, Understand, Succeed and this particular scoring model was developed by Experian. The formula and the score calculation system was developed solely keeping consumers in mind. Unlike the FICO score scale, the PLUS score ranges between 330 and 830. The Experian PLUS score is not the same as the Experian ScoreX PLUS which is not available to consumers.

The Vantage Score

This particular scoring model was developed in 2006 as a joint venture between the top 3 credit reporting agencies. The scoring model had been developed to compete with the FICO model and scoring system but failed to catch on. Very rarely do lenders and financial institutions use this particular scoring system. One of the major advantages of the VantageScore model is that the score gaps between reports generated by all the 3 major CRAs are significantly smaller since the scoring model and the underlying computational algorithm used by the 3 CRAs are more or less the same. The VantageScore scale ranges from 501 to 990.

There are two more scoring systems that are little known and rarely used by consumers. These are:

TransUnion TransRisk Account Credit Score

The proprietary scoring model was developed by TransUnion and free credit score providers like Credit Karma are known to use it. TransRisk offers separate scores for home and auto loan accounts. Their scoring scale ranges from 300 and 900 while home and auto credit score scale ranges between 150 and 950.

Equifax Score Power

This particular score is not based on a different scoring model. Rather, it is the name Equifax uses for the FICO based score that appears on the credit reports generated by Equifax.

One of the more important things to note is that the score varies according to the scoring model used for the calculation. Therefore a FICO score of 750 is in no way comparable to a PLUS score of 750. Other than these 5 scoring models there are a few others that use different parameters to calculate credit scores although most lenders refrain from using them.

What's in a score?

As mentioned, creditors, especially those in the home mortgage industry, frequently use these scores while deciding on who will get the loan and at what rate. However, it's worth remembering that creditors also consider other information, such as your employment history, when making decisions regarding the loan.

Credit score - What it means

A credit score is actually a 3-digit number that usually ranges in between 300 and 850. The higher your score, the better are your chances to take out a loan at favorable terms and conditions. Your credit score is calculated as per FICO (Fair Isaac Corporation) credit scoring model.

Your credit score is determined by your credit history. Each time you utilize credit in any form, it is recorded as a line item on your credit report. Both positive and negative highlighted actions are recorded in your credit history such as paying off a debt (positive) or defaulting on a debt (negative).

Lenders, insurance agents, and even some employers look at your credit report in order to see how well you have handled past credit. Your credit score, therefore, determines what type of offers you receive. The higher your credit score, the better deals you will receive. The objective, therefore, is to only have positive items recorded in your credit report which will give you excellent credit and the absolute best loan deals.

Credit score - Its components

Though the actual formula that FICO uses to calculate your score is secret, yet there are certain components on the basis of which your credit score is calculated. The components are discussed below:

  • The payment history:

    About 35% of your credit score is based on how you have made your debt/loan payments till date. It includes your credit card payments, mortgage payments, and other loan payments along with wage garnishments and/or lawsuits that have been taken against you. So, make your payments on time to have a good score.
  • Your outstanding balance

    : It gets about 30% weightage for your credit score calculation. If you have too many debts, then it is evident that you haven't been able to manage your credit accounts well. This usually happens when you take out too many loans that might lead to loan defaults.
  • The length of your credit history

    : How long you have been taking out a loan or using credit is a major constituent of your credit score. So, even if you have been making your payments before the due date and you don't have too many loans outstanding, your credit score can be a bit low if you don't have a long credit history. About 15% of your score depends on this criterion.
  • New credit you have taken out:

    About 10% weightage is given to this factor when your credit score is calculated. If you open too many accounts recently, then it'll negatively affect your score. A number of hard inquiries in a specific time also affect your credit score negatively. So, do not apply for too many credit accounts in a short period of time.
  • Types of credit you use:

    This factor constitutes about 10% of your credit score calculation. It is dependent on the various types of loans you have. It is better for you if you have different types of credit accounts instead of only revolving credit accounts, that is, credit cards.

Personal details such as race, gender, and religion are not considered while determining your score.

Each major credit bureau has its own method for calculating credit scores. However, the scoring models have been fairly standardized so that a score of "600" at one bureau is roughly equivalent to the same score at another.

It is advisable that you check your credit reports at regular intervals and dispute to correct errors if any. If there's any negative item in your reports and they are correct entries, then try to add positive information in your reports. Also, check your credit score once a year so that you have clear knowledge regarding your score and you can try to improve it, if required.

What's a good score?

Overall, a score of 750 or above is a sign of very good credit and a very good credit score. People with scores of 750 or more, all things considered, have a good chance of obtaining quality loans at the best interest rates.

Excellent Credit: Over 800

A credit score that is rated above 800 is considered excellent. To achieve excellent credit, you shouldn't have had any negative line items recorded on your credit report. You should also have shown a stable work history and will have successfully handled various lines of credit like revolving credit and installment loans. An excellent credit score will get you the absolute best deals.

Very Good Credit: 750 - 800

A score that falls in this range shows that you have been responsible for handling a variety of credit types and have practically no negative line items recorded. Usually, the one item that keeps people from an excellent rating is a high debt-to-income ratio which means you have more debt than you should according to your income level. A very good credit score will still get you great deals.

Good Credit: 700 - 750

This range shows viewers that you have worked to establish a solid credit history. You may have had problems with employment or paying bills on time, but you have worked to overcome them. Having a good credit score range will still help you get competitive interest rates and low fees although loan rates and insurance premiums will be a bit higher than if you had very good to excellent credit.

Fair Credit: 650 - 700

If your credit score falls in this range then it shows you have had some credit problems. Fair credit can stem from various late payments, having too much debt, or one or more collection accounts. Expect to have problems obtaining unsecured loans and some jobs as well as paying high interest and premiums.

Bad Credit: 600 - 650

With scores below 620, consumers may still obtain a loan. However, getting a loan in such cases will be tough, as creditors consider scores below this value to be an indication of greater credit risk. A bad credit rating normally comes from mismanagement of credit through missed payments and delinquent accounts. High-interest rates and premiums, large down payments, and significant collateral will be required.

Very Bad Credit: Under 600

It will be extremely difficult to get credit or insurance and, if you do, it will involve extremely high interest or premiums, down payments, and collateral requirements.

Credit report and score - 6 Important facts you might not know

Do you know your credit utilization ratio or how long a card will continue affecting your credit reports after you close it? Here are 6 such things which you need to know in order to build a good credit record and have a good credit score.

  1. You lose the value of a card as soon as you close it

    The value of your credit card still remains after you close it. For example, a card you close today, its payment history will continue reflecting on your credit report till about 10 years. However, any negative item on the card will not affect after 7 years. Therefore, the good and bad things on the card will continue affecting your credit score for some years (7 or 10 years depending on the item) even after you close it.
  2. The major 3 credit bureaus evaluate your credit score

    The 3 major credit bureaus, namely, Equifax, Experian, and TransUnion, generate your credit reports on the basis of your financial transactions which get reported to the bureaus. However, they do not judge your credit report or advise the creditors/lenders regarding approving or denying your loan applications. There are companies like FICO and VantageScore Solutions, which evaluate your credit report and assess your credit risk level and assign a credit score. The lenders and creditors get these scores to assess your creditworthiness and on the basis of that, they agree or deny your credit/loan application.
  3. Medical debt is viewed differently on the credit report

    Debt is always debt, and there's no exception about a delay in medical debt payments. However, usually, medical bills are not reported to the credit bureaus until they are sent to the collection agencies. You should also know that the more recent the medical debt is, the more is its negativity on your credit score.
  4. You do not have to worry about your utilization rate

    The utilization rate is actually an important thing. In order to calculate your credit utilization percentage, simply divide your outstanding credit card balance by your total credit limit (considering all your credit cards) and multiply the result with 100. The lower the percentage, the better for your credit score and vice versa. It is better if it is within 30%.
  5. You need to have debt in order to build or rebuild your credit

    How good it would have been if it was true. However, in reality, it’s not mandatory to have a debt to build or rebuild your credit record. If you carry debt and continue making only the minimum payments on your cards, then it will affect your credit score negatively. Therefore, do not max your credit cards and try to pay the outstanding balance every month to build a good credit record and have a good score. What the credit-scoring models assess is whether or not you are able to manage your credit and loans properly and whether or not you are able to make the required payments on time.
  6. You should not obtain new store card as it may hurt your score

    In reality, this is not always true. It may be a good option when you do not qualify for other types of cards. So, if you are looking to increase your utilization rate, then you can go for such a card as it will raise your overall credit limit instantly. However, do not use this card for buying things you do not require; on the contrary, use this card carefully so as to not build additional debt.

Gathering this knowledge will help you build a good credit record which in turn, will help you achieve a good credit score. In turn, you can take out loans at favorable interest rates and build a better financial life.

Is credit score more important than Social Security Number?

Generally, most of us tend to ignore our credit score.

But, we forget that our credit score is as important as our Social Security Number (SSN).

So, no matter what, you must keep a close watch on your credit score.

If you are neglecting your credit score for long, it’s time you should pay attention to it. If you have a poor credit score, take steps to increase it; because, a bad credit score will get you nowhere financially. But, with a good credit score, you’ll be able to overcome the most difficult financial situations.

Why is your credit score more important than your SSN?

A Social Security Number is proof of your identity; whereas, a credit score shows your creditworthiness to your creditors or lenders.

A credit score is more vital than your SSN when you’re dealing with your finances.

Why it’s important to have a good credit score for your financial well-being

  1. Grab better loan rates

    You must know that the economy functions on credit. Whether you want to take out a mortgage, car loan, or student loan, a good credit score will help you to get the best rates on your loan. This is possible because creditors or lenders will see you as more creditworthy.
  2. Save money on interest rates

    A good credit score helps you save your precious dollars on interest rates while obtaining a loan. However, your credit score will be reviewed by insurance companies, landlords, and employers also. A high credit score will portray your responsible nature to them.
  3. Save dollars on insurance coverage

    Who wants to risk his/her business by providing service to a person with a devastating credit history? No one would do that. Your credit score will be checked even if you want to get life insurance coverage.

    Most insurance companies use the credit-based insurance score (CBIS) to make you qualify for coverage. An excellent credit score will automatically increase your CBIS and lower your monthly insurance premiums.
  4. Get increased credit limits

    Creditors will consider you as a responsible credit card holder and can automatically increase your credit card limit if you have a great credit score. Plus, you won’t have to negotiate hard for an increase in your credit card limit.
  5. Get amazing credit card deals

    You can get excellent deals on credit cards like alluring reward points, cash-back deals, free gifts, or low introductory rates, if your credit score is high. Go on paying your credit card bills on time and continue enjoying these services.
  6. Give you more negotiating power

    Whether you apply for a loan, get insurance coverage, or increase your credit line, a high credit score will provide you with more negotiating power. If you have a good credit score, use it to get low-interest rates on your loan.
  7. Pay no security deposit for basic utilities

    Your utility, cell phone, and cable TV providers check your credit score before signing a contract with you. If you have a low credit score, you’ll have to pay a security deposit (generally of $100 to $200) before enjoying their services. However, with a good credit score, you don’t have to pay any security deposit for these services.
  8. Help to identify a fraud

    You can spot a fraudulent activity if you constantly keep a watch on your credit score. For instance, if you notice an unexpected drop in your credit score, it means your credit information has been stolen. If this happens, you must immediately report this scam to the credit reporting agencies and get it removed from your credit report.

Thoroughly monitor all your free credit reports annually from the 3 credit bureaus.

However, protect your SSN to avoid being a victim of identity theft. You may face consequences in your social life if your identity is stolen.

Last Updated on: Thu, 27 Aug 2020