Understanding your Credit Score

Once upon a time, people traded to get the things that they wanted, bartering goods for services or other goods. As time progressed, they learned to use a different type of bartering system – one that relied on currency.

Money was used to pay wages for work done and to buy food, purchase land and build homes. When times were hard and money was in short supply, businesses would let people they personally knew use credit to buy items they needed until they could obtain and pay the money. People with a surplus of money on hand found it advantageous to lend that money to those who didn't have enough. They could earn a return on their investment by charging interest on the money they loaned. Looking at today's world, we can see that it revolves on credit. We buy things on time and pay them back with interest. Homes, cars, furniture, appliances, and even our clothes and groceries are purchased in this manner. Unfortunately, with the abuse of this system, the rich get richer and the poor typically stay that way…but that's another story.

But, the wonderful world of credit didn't automatically tell us that we would need to save money in order to pay for all of the things we bought. Consequently, people miss payments, default on loans, flip debt from one credit card to another, or borrow against what they have, essentially creating more debt to pay off other debt. In order to navigate the world of credit successfully, you must be responsible with money or you'll simply end up with endless debts. So, let's take an in-depth look at the subject, to see what we can learn about the advantageous use of money and credit, while avoiding their pitfalls.

Your Credit Score

Many people can only guess at what their credit score actually is. At one time, no one was allowed to know because it was used by banks and other lenders to determine your eligibility to receive money or products from them. Nowadays, thankfully, all you have to do is request a copy of your credit report to find out that magic number.

Your credit score is a three-digit number that wields a lot of power in the world of credit. A more common name for it is a FICO score, named after the firm that came up with the modern credit scoring model, the Fair Isaac Corporation. Suffice to say, the way that the score is calculated is a complex (and closely guarded) algorithm that all but the most learned mathematicians wouldn't understand. There are other credit-scoring methods, but FICO is the most well-known. Individual businesses may also employ their own methods for determining their lending eligibility.

Let's consider the FICO system for a moment. The scoring numbers range from 300 to 900, approximately. As you might imagine, a higher number is better than a lower one. A credit score is a compilation of a number of things. One major part of the equation is your credit history. Every time you open an account at a store, apply for a credit card, make a payment, make a purchase or close an account, these actions become a part of your credit history. It creates a trail that shows lenders how you handle the responsibility of credit.

Lenders can take the time to pull your credit report and read it, but in the interest of time, being able to access a single three-digit number is much more convenient. This number-scoring system has made it possible for shorter turnaround times on loan requests for homes, cars and cash. And with the accessibility and speed of the Internet, you can now access a bank or other lender’s website, punch in a few bits of information, and within twenty-four hours or less receive an answer to your loan request. The credit score allows lenders to automatically say "yea" or "nay" to your request. The amount that you qualify to receive will be based on the category that your credit score falls into.

The credit score is calculated from various pieces of information gathered from your credit report. According to the FICO model, and based on a total of 100 percent, a score is made up of these components:

  • 35 percent – credit payment history
  • 30 percent – amount of outstanding debt
  • 15 percent – length of credit history
  • 10 percent – types of credit you currently have
  • 10 percent – number of inquiries on your credit report

Let's examine each of these components separately.

First, your credit payment history. Obviously, everyone knows that it's better to pay your bills on time. When you don't, it can be recorded on your credit report. Late payments (those that fall 30-, 60-, 90-, or 120 days or more overdue) are a major concern to credit lenders. They could discourage lenders from taking a chance on you with their money. But, virtually everyone has experienced a rough patch or two in their finances from time to time, perhaps from a job-loss or large medical bill. It's always best to contact the creditor during difficult times so that your payment history won't reflect overdue amounts.

Next, the amount of any outstanding debt. Have you maxed out your credit cards? Unfortunately, many consumers habitually do. Experts suggest that you use no more than 30- to 50 percent of your available credit. This provides a cushion and makes emergency funds available if you are ever in dire need. Besides, using the full limit could signal to a potential lender some sort of financial trouble in the works. With several lines of credit at their limit, you'll need a significant amount of money just to meet the minimum required payments each month.

Next we have the length (or age) of your credit history. The longer you've had a credit relationship with a lender, the better it reflects upon you. Short-term credit histories don't necessarily give an accurate or reliable picture of your responsibility with credit or how your handling of it may have changed over time – whether good or bad. So, lenders like to see a longer history.

The types of credit you currently have. This includes all of your credit, whether it's plastic cards or a line of credit at your local bank. Loans for homes and cars are also factored in here. Experts say that you should have a combination of credit types instead of just credit cards or only loans, but there is no concrete evidence that one way is actually looked upon as better than another.

Finally, the number of inquiries on your credit report. An inquiry is a request from someone to receive a copy of your credit report. This does not include what are known as "soft inquiries," which are requests that come from you, an employer, or those companies that send you 'pre-approved' credit card offers in the mail. Too many inquiries in a short period of time may send up a red flag to lenders, causing them to wonder why you suddenly need so much credit.

How credit score are helpful

Contrary to the belief of some, credit scores and reports are not the enemy. In fact, the use of the credit scoring model is helpful to most borrowers. Your credit score is a number. That number falls somewhere on the scale between 300 and 900. That position on the scale helps determine your fate as far as qualifying for more credit. In that regard, your credit score can provide a helping hand.

Loans are approved faster using a credit score as opposed to a credit report. For the most part, lenders have already determined how they'll lend their money based on the scale. A number of 675 may be accepted but with a slightly higher interest rate. A number of 450 will likely be rejected outright. Instead of wading through mountains of paperwork on both your part and the lender's, that number expedites the process. If you call the company and they won't instantly qualify you, you probably don't have to concern yourself with additional wasted time filling out any other paperwork.

Furthermore, it takes time to read a full credit report, and it contains personal information. Part of the reason for credit scoring is so that credit decisions can be made on a fairer basis. There is no discrimination in a number. People can't be denied credit on the basis of sex, race, religion, or nationality. All a lender sees is the number. A credit report also shows your entire credit history from Day One, showing a lender the years that you missed payments or incurred other debt issues. A credit score changes the timeline to reflect the most recent payment information. The number, therefore, might well be kinder to you than the report with creditors.

With the establishment of instant credit systems, the cost (both in time and actual expense) of going through the loan process is considerably less than before. Electronic loan applications can be submitted and processed much more rapidly than paper ones. Credit approval hotlines can access your credit score and return an answer in minutes. The savings can then be passed on to borrowers in the form of less costly loans.

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