What is credit score and how is credit score calculated?

Have you ever pondered over the ease with which you can log on to a website and get your credit approved almost immediately?

Credit score impacts your credit card interest rate

Or when you got prequalification for a car without the company even bothering to ask how much you earn. Or when you get a different interest rate on a loan compared to your friend. Well the answer is simple – these companies check your credit score before making the all-important decision about lending you money.

A credit score by definition is a number calculated using the information present in your credit report based on a mathematical formula. This information is compared to the information of millions of other people in the country and a score is generated that is used at many places to judge the credit worthiness of an individual.

Why is the credit score important?

Your credit score is important because your financial health is estimated based on it. A high credit score signals to the lender that your credit history is good where as a low score indicates that your credit history may be of concern.

  • When you apply for a loan or any forms of credit, the lending organizations check your credit score and the higher it is, the more likely it is that your loan or credit will get approved.
  • You will also have to pay a lower interest rate on loans or credit if you have a high credit score.
  • If one person has a credit score of 520 and another person has a credit score of 720, the difference between the interest rates that both will get can be as much as 4.36 percentage points, as per the web site of Fair Isaac Corp (the company that provides the FICO score). This means that if you are opting for a 30 year mortgage of $100,000, the difference in the interest charges that both these people pay will be $110,325. The monthly payment itself will be different by about $ 307, which is a large amount.
  • If you have a credit card and want an increase in your credit limit or want to request a lower APR, your credit card company will check your credit score to decide whether or not to increase you line of credit and whether to increase your rate of interest or decrease it.
  • Employers look at your credit history and credit score before hiring you and it is necessary to have a good credit score if you want to land a good job.
  • A land lord will also look at your credit score before renting out his or her property to you and if you want to live in a comfortable house, it will be necessary to have a good credit score.

What is a credit score and different categories of scoring:

  • Many different models of scoring are used by lending organizations to take the decision of approving your loan application or rejecting it.
  • The FICO scoring model is the most popular among lenders to calculate your credit score.
  • The scale of the FICO score ranges from 300 to 850 and most people fall between the range of 600 and 800.
  • According to the data obtained from a California company which developed the credit score for the first time and also developed the FICO score for Fair
    Isaac Corp, if you have a scoring of 720 or more on the FICO scoring model, the chances are that you will get the best interest rates on mortgage.
  • The three different credit Bureaus in the United States each use their own scoring system. Equifax uses the BEACON score, TransUnion uses the EMPIRICA score, and Experian uses the Fair Isaac/Experian Risk Model.
  • The credit scores calculated by these three bureaus can be different because they use different formulas to calculate the score. The difference can also be present because of varying data in credit reports submitted to these different bureaus.
  • This situation could change because all the three credit bureaus got together to develop a uniform scoring method called VantageScore. If this scoring model becomes the standard model used by all the three bureaus then the credit scores provided by all three of them will be the same for the same individual. 

How is your credit score calculated?

Since different reporting companies use different methods, let us take a look at how the FICO score is calculated:

The credit score is calculated with the help of many parts of the information that are present in a credit report.

  • This information data is divided into five groups viz. – Payment history, Amounts owed, Length of credit History, New credit, and Types of credit used
  • The weightage given to these five groups in computing the FICO score is as follows:
    • 35% is given to Payment history
    • 30% is given to Amounts owed
    • 15% to Length of credit history
    • 10% to New credit
    • 10% to Types of credit used
  • These percentages are based on how important each category is for the general population and especially the lenders in evaluating credit worthiness.
  • The credit score takes into consideration both negative as well as positive information in a credit report. Late payments of loan installments and utility bills will lower your credit score, but if you have a good track record which says that you make payments on time it will enhance your credit score.
  • The importance of the five categories for different people is different. For instance, if you are a person who has not applied for or used credit for a long time the implications of these 5 categories will be different than a person who uses credit often and has done so in the recent past.
  • The importance of each individual factor in the calculation of your credit score also depends on the other information present in your credit report.
  • For some individuals one particular factor may have a different impact compared to another person who has a different type of credit history.
  • Your credit score will also change according to the changes in your credit report and so will the importance of every different factor while calculating your credit score.
  • Hence we cannot really determine how important one factor is in the calculation of your credit score without having a look at the entire credit report as a whole.
  • The levels of importance given to the different factors as mentioned earlier are meant for the general population. However, different weight may be given to these factors for different people according to their different credit profiles.

Although lenders tend to look at additional factors like your monthly or annual income while deciding whether to give you the loan or not, it cannot be denied that your credit score plays the most important part in the taking of this decision. This is the reason that you should make an extra effort to maintain a high credit score.

photo by: Andres Rueda

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