When an account manager evaluates your application for credit, he must have access to
information about you in order to understand whether you are a justifiable
credit risk or not. This information is obtained both through the information
provided by you in the credit application itself and through your credit
reports received from the credit bureaus. Since, most of this information is in
qualitative terms, evaluating this information and comparing this for different
credit applicants is a difficult task. Therefore, most banks, credit card
companies, financial institutions and many other credit providers develop and
use some kind of credit scoring scheme to make the credit decision. It not only
helps them in fast decision-making but also ensures consistency in credit
A credit scoreis a number used by lenders to decide on the consumers' credit rating and ultimately to decide on whether to extend credit to a particular consumer. The aim behind using credit score is to understand the risk involved in extending. This is why credit scores are also called risk scores. In nutshell, it is the reflection of consumers credit history whether good or bad.
The lenders may decide as a policy whether they would like to extend credit to consumers with poor credit or less than perfect credit history and use credit scores to make conscious, accurate and consistent decisions about credit applications. Based on their policy they decide a cut off credit score for approving credit applications. Lenders also use credit scores to decide on the interest premium to be charged from consumers who have credit scores below a particular cut off. From consumers point of view, understanding how credit scores are calculated and used will help them better management of their credit score and avoid situation of bad credit or less than perfect credit.
How is credit score calculated?Credit scoring is a method of evaluating an applicants creditworthiness by assigning values to such factors as income, existing debts, and credit references, etc. It takes inputs from your credit report and your credit application and generates a score (number) based on statistical models. Different lenders may use different methods for calculating scores; therefore, scores differ from lender to lender depending on the type of financial service you are seeking.
The most popular credit score is FICO score. Fair Isaac & Company developed a score, called as FICO score, to estimate the likelihood that you will repay the loan. FICO summarizes your credit history into a single number. There are really three FICO scores computed by data provided by each of the three credit reporting agencies - Experian, Trans Union and Equifax. FICO scores range between 300 and 850. The classification for bad credit varies from one credit extending institution to another. Generally, the acceptable score for first tier credit institutions is 660. However, there are many credit extending institutions that accept scores down to 560. Below this you may have to seek help from bad credit extending institutions.
The FICO has five major components:
- Payment history (Weight-35%)-it includes factors such as number and severity of late payments / non-payments, unfavorable credit information such as bankruptcies, charge-offs, collections, etc.
- Outstanding debt (Weight-30%) which includes factors such as type, number and age of accounts, total debt outstanding, etc.
- Credit history (15%) which includes factors such as the amount of time credit has been established, how often you approach for credit, amount of credit available to you and amount of credit used by you, etc.
- Number of new credit enquiries (10%)
- Types of credit (10%).
One should understand that credit scores are dependent on several factors. These factors keep on changing as your credit records change. As you improve your payment history, credit history and reduce your outstanding debts, your credit scores also improve.
As a consumer you should also understand that these credit scores are not part of your credit report. The lender calculates your credit score each time you request for a credit or loan.
Can I improve my credit score?Of course! You have all the opportunities to improve your credit scores, even if you have a bad credit or less than perfect credit and are suffering from poor credit scores. Some components of your credit score can be managed through better planning in short run, while some components need long-term financial discipline.
Understand that number of new credit enquiries made has 10% weight in your credit score. The more frequently you apply for credit the worse will be your score for this section. With proper planning you can avoid frequent credit application. Shop well and apply only to a few lenders who seem to be most promising for your risk class. If you are facing frequent credit needs, go for a bigger line of credit rather than multiple small credit lines.
In the long run, you can improve your credit scores by maintaining financial discipline in repayment and by reducing your outstanding debt. Inculcate a habit of paying well in advance to avoid last minute problems. Keep provisions for contingencies. Use your credit lines well below the permissible limit (say 60% of your credit limit).
Have a long-term vision for your financial management. Understand that short-term mistakes have long-term repercussions. It does not take much freedom out of you to avoid such mistakes. It is only a matter of having a proper personal financial planning and you can enjoy your financial freedom. So start today. Improve your bad credit or less than perfect credit history into good credit history. There are many effective ways available to do so.