Your ability to be trusted by banks to borrow money is entirely dependent on a three-digit number called your credit score. Before anyone understands what these numbers mean, they think banks, in some magical way, are able to sense them. In reality, this is a much less mystical process. A credit score is essentially a short-hand way to explain your financial character through numeric digits; lenders look to this number before they will consider lending you money.
The credit score consists of numbers ranging anywhere from 300 to 850, and it determines how much you pay in interest, whether your loan will be approved and how well you can maintain a financial life. There are some people out there who have credit scores of zero, simply due to the fact that they have never participated in the borrowing and lending network. No one assumes that these people are irresponsible with their money.
In the past, scores were computed solely based on the judgement of a third party, typically referred to as a “loan officer”. Loan officers used to have personal relationships with their borrowers and were able to evaluate them based on their character, not solely on the basis of credit history. The creation of the credit score was developed to create a more standardized process for lenders to evaluate the financial responsibility of an unknown individual; this is similar to borrowing money from someone you have never met before and guessing whether or not they would pay you back.
Credit bureaus (Experian, TransUnion, and Equifax) keep records of all of your financial transactions and compile them into reports, which are then used to create your FICO score (or Vantage score), which is an indication of how much money you could potentially borrow based on your previous borrowing history. The same data can result in two different scores, but the actual meaning of the two scores is basically the same.
The “goodness” of a credit score is not a universal standard; many people think that a score of 700 is considered good, while some view 750 as excellent. A score of over 650 indicates that you are doing pretty good financially, while over 750 means you have a good grasp on financial matters. If your score is less than 650, you can improve it quickly with a little knowledge of the five factors that affect your score up or down. These factors don’t happen overnight; they build up slowly over a period of time through all the loans you take out and payments you make, as well as all the times you use credit cards and all the other little decisions you make regarding borrowing and debt.
In this particular system, payment history is king; if a consumer has missed any payment even once, they are likely to feel the effects of that missed payment for at least seven years. If a consumer has missed a few more than just one time, the consumer will be automatically categorized by lenders as an “unreliable” consumer, and the consumer will have a significantly lower credit score as a result.
A consumer’s utilization of debt levels is also very important; for example, if a consumer has an $850 balance on a $1,000 credit card limit and pays their bills on time, the consumer is signalling to lenders that the consumer is using too much of the available credit card limit and may be financially stretched. Use of utilization, as a concept, can quickly decrease the credit score of a consumer who pays their bills on time consistently.
What Do Credit Scores Really Represent? – How Does Type of Credit Account (e.g., Credit Mix, Payment History, Credit Utilisation Ratio, Length of Time You Have Held a Credit Account) Affect Your Credit Score?
It’s a factor in your score that builds up so slowly over time you almost don’t notice it. An old student loan (e.g., Twelve Years Old) can still contribute to the overall strength of your Credit Age, and if you eventually paid it off entirely, it may have contributed to your weakest Average Credit Age score. Many people look at this paradox in their scores and think the Credit Scoring System favours people that are in debt for a long period of time over others who have become debt-free. In addition, an old credit card account that is inactive may still positively affect the account’s age and Credit Stability.
There is an additional layer of complexity with Credit Mix. Lenders generally prefer to see different types of credit products available to you, e.g., Credit Cards, Installment Loans, Mortgages, etc. Having access to a variety of products helps demonstrate to a lender that you can handle the responsibility of managing several payment obligations simultaneously without falling behind. In addition, New Credit Inquiries should also play a significant role in your Credit Score.
Every time you submit a New Application for Credit and your Credit Report is Pull by a lender, it will be a Hard Pull. If you have multiple Inquiries on your Credit Report within a very short time frame (less than 12 months), lenders will become concerned that you are desperately looking for Credit. Even though one Inquiry usually drops off your Credit Report after two years, multiple Inquiries demonstrate to the Credit Scoring Algorithm a trend that is unfavourable.
What Is the Effect of Modern Day Credit Scores on Mortgage Approval, Financing a Vehicle, Mortgage Funding, an Everyday Decision-Making Approach to Money Management
The amount of control placed upon an individual due to their credit score is commonly underestimated. The benefits obtained by having a high credit rating include: overall ease of obtaining various types of borrowing (e.g., home mortgages, vehicle financing, personal loans), lower interest rates and better terms when obtaining those loans. The difficulty created by having a low score is generally perceived as an uphill battle to obtain even basic financing.
Some individuals choose not to use credit at all to avoid being in the position of having debt; although this helps the individual feel good about themselves, it results in the individual having a blank credit report that is seen by lenders as being a risk. Therefore, keeping at least one credit card account open and maintained in good standing will help maintain an individual’s financial presence without generating additional interest or debt; this practice will help facilitate borrowing in the future when planning for significant events (e.g., purchasing a new home).
Credit scores are complicated; however, boosting credit scores is often a process that involves strategic positioning. By becoming an authorized user on a credit card account that is managed properly by another person, you are able to improve the credit mix of the authorized user, the credit age of the authorized user, and the utilization ratio of the authorized user instantly. It’s as though you are borrowing someone’s financial reputation for a limited amount of time to allow you to start to build credit while not incurring a high level of risk. When selected correctly, the addition of being an authorized user will actually provide the authorized user with three benefits: a longer credit history, improved utilization ratio, and a more diverse credit mix all from one action.
The Path to a High Credit Score — Responsible Borrowing and Properly Managing Your Accounts
The key to understanding credit scores is not memorizing the actual numbers, but rather, noticing patterns of borrowing and repaying in order to build a good credit score. While the scoring algorithm may have flaws, its intent is to forecast the likelihood that you will repay your debts.
The good news is that while the mathematics behind the algorithm are difficult, the behaviours that increase your credit score are relatively easy: make all payments on time; use only a small portion of your available credit; keep your oldest accounts open; only apply for credit when you absolutely need it; and have a healthy mix of accounts. Over time, these simple habits will create a positive credit profile that will be viewed positively by lenders.
To conclude, the key is to have a full understanding of how things work instead of trying to take advantage of them. Credit Scores show your level of trust and reliability when it comes to managing funds (respect) and how responsible you are with using these funds (maturity).
The more you handle debt with discipline, the more the system will “reward” you for this good behavior while also becoming easier to obtain an excellent score. After obtaining a good knowledge of it, the focus should be less on chasing points or numbers and instead focus on creating an environment in which you feel secure with your financial future.
