About Credit Scores
Credit scores reflect an individual's financial responsibility over a period of time and are used by financial institutions to determine creditworthiness, eligibility for loans, and the appropriate interest rate. The scale for credit score is 300 to 850, with higher credit scores indicating a superior credit history. Individuals with high scores will find lenders competing for their business with low interest rates and better terms. Low scoring borrowers will have to pay a much higher interest rate to convince a lender to put up money. Understanding how credit scores work can help an individual make financial decisions that will lower their costs of borrowing and present new opportunities.
Major Factor: Paying On Time
It wasn't until the age of the Internet that credit scores became easily obtainable and that national legislation was passed to protect consumers from bad information in credit scores. Today it's widely understood which factors contribute to an overall credit score. More than one third is determined simply by whether bills are consistently paid on time. Though a single missed payment won't destroy a person's credit, every late payment inflicts some damage because the most recent activity is weighted more highly than the past. Always paying bills on time will virtually guarantee a fairly high credit score and access to credit open.
Major Factor: Outstanding Debt
Another major factor considered in the credit score is the amount of debt already outstanding. Even the most responsible individual can only afford as much debt as he can service with his income. The more of that capacity is already filled by outstanding debt, the less attractive the borrower will be to potential creditors. This will lower the credit score. So, while having some debt allows regular payments to demonstrate financial responsibility, too much outstanding debt relative to income will be a weight dragging down a credit score. As a result, new loans will come with higher interest rates, higher collateral requirements, and additional documentation.
Other Considerations
The rest of a credit score is based on factors like the length of a borrower's credit history, the types of credit he has, and how much new credit he has recently applied for or obtained. The longer an individual has had credit in good standing, the more reliable he is deemed to be. Individuals with a mix of credit types, such as credit cards, mortgages and other loans, are also viewed to be more responsible and will have a slightly higher credit score. On the other hand, lots of new credit applications can mean financial distress and will automatically lower a credit score.
Credit Reports
The exact methodology for calculating credit scores can differ. The most common, particularly for mortgage applications, is the FICO score. Three companies in the U.S. are responsible for reporting credit scores, and often they provide different ratings, sometimes due to errors or differing access to information. Frequently obtaining a copy of all credit scores and the contents of the credit reports can help protect against such errors.
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