Credit scores help lenders assess the risk of lending money to loan applicants. Many different scoring systems exist, but they all use the borrower's credit history to predict the likelihood of repayment, based on the past behavior of borrowers with similar profiles. Credit scores are one of the most important factors when a lender makes a decision to reject or approve an applicant, and they also affect the rates and terms that lenders will offer.
Importance
Most lenders look carefully at your credit report when you apply for a loan or line of credit. Your credit score reflects the amount of risk you pose to the lender. Low scores indicate a high risk of default, and high scores indicate a good chance of repayment. If you don't have a good credit score, you will usually have a hard time getting credit. If you do get a loan, it's likely to have a higher than average interest rate. If your score is very low, you may not be able to get credit at all. Before the 1970s, standardized credit scores essentially didn't exist, and lenders had to rely on personal judgment when assessing credit risks. Today, credit scores reflect detailed statistical data from borrowers with a similar financial background, and are accordingly far more consistent.
Other Factors
Although credit scores are an important part of the equation when lenders appraise credit applications, they are usually secondary to an analysis of the applicant's overall financial situation. Initially, lenders use credit scores to weed out applicants are who are statistically likely to miss payments or default. After weeding out such customers, lenders conduct a more thorough investigation of the applicant's financial status and risk factors. This is known as "underwriting," and includes setting an interest rate based on the applicant's income, employment history, credit score and other factors.
Favorable Scores
Most lenders have a cutoff score for high-risk applicants, as well as a minimum eligibility score for the best interest rate. Different agencies generate different credit scores, but according to the widely used FICO scoring system, which ranges from 300 to 850, any score above 700 is likely to qualify for a prime-rate loan. In the wake of the 2008 financial crisis, favorable credit scores have become more important than ever. Lenders tend to be much less willing to approve borrowers who have low scores, or no credit history at all.
Tips
The factors that comprise your credit score include payment history (35 percent), debt obligations (30 percent), length of credit history (15 percent), new credit accounts and type of credit (10 percent each). Improving each of these areas will help you get the best credit score. Make at least a minimum payment on your debts each month; if you have extra income, shift it to the debt with the highest interest rate to boost your payment history and reduce the amount you owe. Responsible use of various kinds of credit (e.g., a credit card, a retail card and a mortgage loan) generally helps your score. It's a good idea to have at least one credit card, but only charge a small amount to it and pay the bill in full each month. You should also try to limit applications for credit, because new accounts tend to lower your score and reduce the average length of your credit history.
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