Now a day’s more and more people are increasingly becoming dependent on “Credit.” When that’s the scenario, you invariably have to keep an eye on your credit reports and credit rating (score) as your credit score is an indicative of your credit worthiness. Credit score helps to determine your present credit position.
You have to understand the fact that your credit score plays important role in your financial life. Be it your credit card approval or your loan application, your credit score determines whether you are fit for getting that financial instrument or not.
A bad credit score can eventually ruin your financial life.
So let’s understand in depth about credit score and its importance and go onto learn how it is determined and see the tips for maintaining good credit score.
What is a Credit Score?
Basically, a Credit Score is a three-digit number ranging from 350 (extremely high risk) to 850 (extremely low risk) which is calculated from the information contained in your credit report. In simple words, it is a numeric expression describing your credit worthiness. Credit Score employs statistical methods to ascertain when an individual is likely to pay back the money which he or she has borrowed.
There are three main credit bureaus in the U.S., which take up the task of determining credit score for individuals. These are Equifax, Experian, and TransUnion. Each of these credit bureaus uses different evaluation systems taking into account different set of factors to determine credit score.
Primarily they consider information contained in credit report. Some of the other common factors employed in calculating credit score include credit payment history, credit type mix, and time length of credit history, current debts, and frequency of new credit applications.
The factors responsible for calculating credit score are weighed differently and so the actual credit score issued by each of the credit bureaus tend to differ although the credit score is based on the same credit report information.
Apart from using credit score, most countries also employ a scale of 0 – 9 to rate your personal credit. In this scale, each number is preceded by either of the two letters, that is “I” or “R”. The letter “I” signifies installment credit ( for home or auto financing) whereas the letter “R” signifies revolving credit (for credit card). Each creditor issues its own rating for individuals. Let’s take an example. A rating of R1 with Visa signifies highest level of credit rating whereas you may get a rating of R5 with MasterCard if you have not paid MasterCard bills for many months.
How your Credit Score is determined?
When you borrow money, the lender sends detailed information to a credit bureau describing how well you handled your debt.
This information is sent in the form of a credit report. The information contained in the credit report is the base for determining the credit score for an individual.
A credit score is determined using five major factors. These factors are previous credit performance, the current level of indebtedness, types of credit available, time for which credit has been in use and the pursuit for new credit. All these factors are taken into account when a credit score is calculated.
However, they get different weighting.
For example, a weighting of 35% is given to previous credit performance. A weight of 30% is given to the current level of indebtedness whereas a weight of 15% is given to types of credit available and also to time credit has been in use. A weight of 5% is given to the pursuit of new credit.
So you see that your previous credit performance is by far the most weighted factor when it comes to calculating your credit score. When you pay off your debts regularly and quickly, your credit score tends to increase. In addition to good credit history, having low levels of indebtedness also helps to boost up your credit score.
The Importance of your Credit Score
Whenever you apply for a credit card, home or for auto loan your credit score is checked. If your credit score is low, then your loan or credit card application approvel chances are less and it might be rejected. Your credit score determines what level of risk you pose to your lenders. A low credit score means that the lenders might reject your application for loan or credit card. So your credit score follows you whenever you apply for a new credit. Another consequence of poor credit score is that lenders will lend you money at a high rate imposing what is known as a risk premium. So, for a person with poor credit score his interest rate tends to be on the higher side drastically impacting the monthly payments. Let’s take an example to demonstrate the importance of credit score. Suppose your credit score is 800 you might let loan at 5.50% while if your credit score is 500, your interest rate can be as high as 9.50%.
Tips for Maintaining a High Credit Score
- Do not overextend your credit.
- Make all Loan Payments on time and for the correct amount.
- Do not ignore overdue bills.
- Keep outstanding debt as low as possible.
- Be aware of the type of credit you have.
- Limit your number of credit applications.
- Be regular in your debt payments.
In today’s lifestyle, it has become nearly impossible to live without credit. So it is important for you to understand the importance of credit score, how it is determined and should know how to improve your credit score. A high credit score is important for a healthy financial life and you should make every effort so that your credit score is never on the lower side. To enjoy financial freedom, you should fiercely guard your credit score so that it helps you in getting your desired credit amount at low rate of interest. Always remember that your credit score is indicative of your credit worthiness. So build your credit score to improve your credit worthiness.