What is a Credit Score & How Does It Work?

The following is a guest contribution by Patrick Ward:

Whenever you make an application for loans, one of the factors that will be used for qualifying you is the credit score. A credit score is the number that is used to determine the risk associated with lending money to you. This is the number that tells the banks, credit card companies, and other financial institutions whether you have the ability to pay off your debts.

In the United States, the most common credit scoring system used is called FICO. FICO scores range from 300 to 850. The scores are classified as follows

  • Excellent credit: This is anything above 720
  • Good credit: Between 690 and 720
  • Average credit: Between 630 and 690
  • Poor credit: anything under 630

The other credit scoring system used is the vantage score

Several factors determine the FICO credit score. Here is how credit scores are arrived at. They include:

  1. Payment history: Making payments on time results into a higher credit score. Payment history accounts for 35% of credit score.
  2. Amounts owed and available credit: The amount owned in relation to available credit accounts for 30% of the score.
  3. New credit: When you open a new account, it proves that you are creditworthy and thus improves your credit score. This accounts for 10%
  4. Type of credit: With a mixture of different types of credit, you improve your score. It accounts for 10% of the credit score.
  5. Recent credit: Your open accounts and account activity account for 15% of the credit score.

Application of credit scores:

  • Leases

A landlord may check the credit scores of a tenant to help determine how much money they will charge them.

  • Approval for financial products

Financing bodies will look at your credit score to determine if they will approve your loan application.

  • Interest rates

The interest rates you get can also be determined by your credit scores. With a higher FICO score, you are likely to be approved for credit with lower interest rates. However, with a lower FICO score, your chances of being disqualified are high and if you are approved, the interest rates may be raised.

  • Best credit cards and lucrative credit card rewards

If you want to get invitations from the best credit card companies, you should work on attaining a good credit score. Attaining a good credit score is not that easy since you can harm your credit without being aware of it. The bottom-line of this is that you must give importance on your credit score and see to it that it shows good standing; overlooking this can be very detrimental to your financial health. Thus, being aware of how your credit score is calculated is necessary.

Usually, the best cards and reward programs are given to those with very high credit score ratings. Because getting high credit score ratings means lower interest rates, approval of higher limits and more rewards. It results to lower interest rates because a lender takes note of your credit history. Relying on your credit score, lenders will determine what kind of risk you expose them. According to financial theory, increased credit risk entails additional risk premium added to the price of money borrowed. The higher the credit risk, the higher the risk premium added.

Next, it also results to approval of higher limits. Lenders will be more willing to lend you larger amounts of money with a good credit score because they know you have a good credit standing. It does not only help you have greater purchasing power, but it also allows you to potentially raise your credit score.

Moreover, such lenders offer the best cash back, travel points and other rewards. Even some offer dollars worth of bonuses for spending certain amount of money in an allotted time. By following tips and suggestions, you should be able to maintain or improve your credit score. Again, getting approved and garner such perks, however, requires you to have a favorable credit score.

Keeping good your credit score with making wise credit decisions and developing healthy credit habits will lead you into raising your credit score and maintaining it. Because of all the benefits, a good credit score is something to feel good about and to take good care of, since it influences your financial freedom.

Author Bio:

Patrick Ward is a legal researcher specializing in finance, loans and debt analysis, and bankruptcy law. He has a decade of experience in analyzing the legalities involved in the dynamics between local and global financial institutions. He is also passionate in helping individuals overcome their financial challenges. Follow on twitter @blgbankruptcy