A credit score is based on a statistical profile that determines, in theory, how likely you, as a borrower, are to default on a loan. The higher the score, the less risk that you pose to the lender. Credit scoring was first developed by the Fair Isaac Corp., who created the proprietary formula used to calculate the risk-based credit score.
Reasons for a Credit Score
Credit scores are useful to a lender because the score provides a standard by which it can quickly evaluate a borrower. Credit scores only consider information in your credit report, and do not take into account other information that is not relevant to your creditworthiness. One type of credit score is called the FICO score, named after the creator of the scoring model. Former E-loan president Joe Kennedy said, "The FICO score is the single best summary score of one's creditworthiness."
Credit Score Factors
Your credit score is designed to take into account all of your credit report information, but it gives more weight to some information when calculating the score. Past payment history is one of the most important factors in the score, with how you use credit being close behind. If you carry balances on your cards that are more than 30 percent of your available credit, your score will suffer because that is considered poor use. The age of your credit file and how often you apply for new credit, as well as the types of credit you carry are also considered in your score.
What Is a Good Score?
Each individual lender will have different ideas about what is an acceptable credit score based on their own underwriting requirements and the interest rates on the loan, with higher-risk customers paying a higher interest rate. Generally speaking, a score of 750 to the maximum 850 is considered to be a prime score, and should qualify you for the best interest rates. Scores below 660 are considered subprime, and generally do not qualify for the best loan rates and terms. Score requirements may also vary depending on the type of credit that you are applying for.
Benefits in Knowing Your Score
In the past, the FICO score was kept secret from consumers, much like the formula used to calculate the score still is not published. In the early 2000s, companies began to release credit scores to people, even allowing them to purchase subscriptions that monitored their credit score for changes. When you are aware of your score, and the information that determines it, you can make financial decisions that will improve your score over time.
Credit Score Problems
Your credit score does not take into account many factors that contribute to your overall financial health. Net worth is an important indicator of how well you are doing financially, but is not a factor in the FICO score. Income, as well as debt to income ratio are also not considered. Many consumers are overly concerned with their FICO score as a measure of their financial success, and make financial decisions based solely on that score, rather than taking into account other factors that may be more important.
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