What Is A Credit Score?
How much interest a lender charges is directly related to the level of risk presented by a borrower. The borrowers that lenders deem less likely to pay back their loans will receive a higher interest rate than those who pose a lower degree of risk.
The major factor lenders use to determine this is the credit score. A credit score is a numerical representation of an individual's creditworthiness. It grades individuals on a scale of 300 - 850 and is based on several criteria.
Here we will look at what factors go into determining a credit score, how lenders use a it, as well as ways one can improve their credit score.
What Are The Factors That Impact Credit Scores?
When a lender decides to pull an applicant's credit report they use one of three services - Experian, Equifax, and Transunion. In the past, different reporters often provided different scores. In 2006 the three credit report services developed VantageScore to standardize all credit scores and reporting.
While the exact method used to determine one’s credit score is not known we do know the basic factors that are considered.
- Payment History: Missed or late payments can heavily impact an individual's credit score. Payment history is one of the largest factors considered
- Debt-To-Income Ratio(DTI): DTI measures how much of an individual's gross monthly income goes towards making their monthly debt payments. Those with a high DTI may not have the financial resources to take on another loan and for this reason, it is heavily scrutinized. Most lenders consider a DTI ratio of over 36% to be high.
- Credit Utilization Ratio: This metric refers to how much of an individual's available debt they have used. For example, if an applicant has a total of $5000 worth of credit extended to them, of which they have used $2500, they would have a credit utilization ratio of 50%. Lenders like to see applicants with a ratio of 30% or less because it indicates responsible credit use.
How Credit Scores Work
As previously stated, the exact formula credit bureaus use for calculating a credit score is not publically available. This being said, we do know how much different factors are weighted in the overall calculation.
- 35% Payment History: How often the individual makes at least the minimum payment on time
- 30% Total Owed: This looks primarily at factors such as credit utilization ratio and debt to income ratio. It tracks responsible use of debt
- 15% Total Credit History Length: A lengthy credit history will generally increase one's credit score
- 10% Credit Mix: Lenders will assess what type of debt an applicant possesses. Those with large amounts of high-interest debt are generally given a lower credit score
- 10% New Credit: When lenders see several new debts on an applicant's credit history it is looked poorly upon. it could mean that the individual is experiencing some kind of financial distress that has resulted in them opening up several new accounts
What Is A Good Credit Score?
Credit Scores are graded on a scale of 300 - 850. We have gone over in detail what factors contribute to one’s credit score but many may be wondering what is considered a good and bad credit score.
- Exceptional 800 - 850: Securing new debt should be little trouble for individuals at this level
- Very Good 740 - 799: Applicants at this level can expect to be approved and receive low-interest rates from the majority of lenders
- Good 670 - 739: According to research, only 8% of individuals in this range are likely to become delinquent in their debt payment obligations. Good credit is the most common score
- Fair 580 - 669: Approval rates are lower and interest rates are higher at this credit range. Most lenders view individuals with a fair credit score as subprime borrowers
- Poor 300-579: Most applicants with poor credit will be required to secure a loan with a deposit or asset to gain approval
How Can I Improve My Credit Score?
- Lower DTI Ratio: Aggressively paying down debt using techniques such as the debt snowball method or the debt avalanche method can reduce one’s DTI and Credit Utilization Ratio, thus increasing their credit score
- Make Payments On Time: Since payment history accounts for 35% of an individual's credit score, continually making at least the minimum payment on time is a must
- Debt Consolidation: Consolidation loans make it much easier to manage debt and can often lower the overall interest rate on an individual's debts. It is a commonly deployed strategy
Having a poor credit score can make it difficult to secure loans and can mean high-interest rates for those that do. Maintaining a quality credit score is an important part of managing one’s financial situation and should not be taken lightly.