How Credit Scoring Works
Credit scoring is a method of evaluating your creditworthiness to determine how likely you are to repay your debts. When you apply for a loan, credit card, or other form of credit, lenders will check your credit score to decide whether or not to approve your application.
How credit scores are calculated
Credit scores are calculated using data from your credit report, which is a record of your credit history. Your credit report contains information about your credit accounts, such as credit cards, mortgages, and loans. It also includes information about your payment history, how much outstanding debt you have, and how long you’ve had credit. This information is used to calculate your credit score.
There are several different credit scoring models in use today, but the most commonly used model is the FICO score. FICO scores range from 300 to 850, and anything over 700 is generally considered a good score. The higher your score, the better your creditworthiness and the more likely you are to be approved for credit with favorable terms.
The factors that impact your credit score
There are several factors that impact your credit score, including:
- Payment history: This is the most important factor in calculating your credit score. Late payments, missed payments, and other defaults will have a negative impact on your score.
- Credit utilization: This is the ratio of your outstanding debt to your available credit. High utilization can negatively impact your credit score.
- Length of credit history: This is the length of time you’ve had credit. The longer your credit history, the better your score.
- Types of credit: Having a mix of different types of credit, such as credit cards, loans, and mortgages, can positively impact your score.
- New credit applications: Applying for too much new credit can negatively impact your score.
Improving your credit score
If you have a poor credit score, there are steps you can take to improve it:
- Make your payments on time: This is the most important thing you can do to improve your credit score.
- Pay down your debt: Reducing your outstanding debt can improve your credit utilization ratio.
- Check your credit report for errors: If there are errors on your credit report, such as accounts that don’t belong to you or incorrect payment information, disputing these errors can improve your score.
- Keep your credit accounts open: Closing credit accounts can negatively impact your credit score, so it’s better to keep them open, even if you’re not using them.
- Apply for new credit only when necessary: Applying for too much new credit can negatively impact your score, so it’s best to only apply for credit when you really need it.
How lenders use credit scores
Lenders use your credit score to help them decide whether to approve your loan or credit application. They also use your score to determine the interest rate and other terms of your credit, such as the credit limit.
For example, if you have a high credit score, you are likely to be approved for credit with favorable terms, such as a low interest rate and a high credit limit. If you have a low credit score, you may be approved for credit, but with less favorable terms, such as a higher interest rate and a lower credit limit.
In some cases, lenders may also use other factors, such as employment history or income, to help determine your creditworthiness. However, your credit score is usually the most important factor in the decision.
Credit scores and employment
Employers may also check your credit score as part of the hiring process. However, they can’t check your credit score without your permission, and they can only use your credit score to make decisions if the job is related to finance or requires handling money or sensitive financial information.
Credit scores and insurance
Insurance companies may also use your credit score to determine your eligibility for insurance and the rates you pay. For example, if you have a high credit score, you may be eligible for lower insurance rates.
However, some states have banned the use of credit scores in insurance underwriting, so it’s important to check the laws in your state to see if this applies to you.
Conclusion
Credit scoring is a method used by lenders, employers, and insurance companies to evaluate your creditworthiness. Your credit score is calculated using data from your credit report, and there are several factors that impact your score, including your payment history, credit utilization, length of credit history, types of credit, and new credit applications.
If you have a poor credit score, there are steps you can take to improve it, such as making your payments on time, paying down your debt, and checking your credit report for errors. Lenders use your credit score to help them decide whether to approve your loan or credit application, and insurance companies may use it to determine your eligibility and rates.