This is How the Credit System Works!
We all require some form of credit from time to time, whether it is in the form of installment credit like a home loan or the form of revolving credit like credit cards. When we borrow funds, we are liable to pay back the funds to the lender. All related information is collated by the credit bureaus and is used to calculate our credit scores — understanding how the wheels of the credit system churn will help us manage our debt better.
There are a host of credit scores available, but the most popular go-to score is the FICO score. The three main credit bureaus – Experian Equifax and TransUnion compile different FICO scores because of varying algorithms they use. FICO scores have a range of 300 – 850 with 850 being indicative of an excellent borrower. There are several contributing factors that determine where in that range you stand. Lenders use the score to determine the degree of risk they take before financing a prospective borrower.
Factors that influence your FICO score
Payment history - makes up 35% of the FICO score. The payment amounts, due dates, late payments, whether you have defaulted on a loan and various other data contribute to your payment history.
Credit utilization ratio – contributes to 30% of your FICO score. It is calculated by dividing the total amount of revolving credit by the total credit limit available to you. In other words how much of your available credit limit have you used? A good ratio is anything below 30%. So if your total credit limit is $2000, having an outstanding of less than $600 would be a good credit utilization rate.
Length of credit – If you have a long history of making timely payments and managing your debt well, this factor will add a further 10% to your FICO score.
Types of credit – Contributes to 10% of your score. Your credit mix, from installment to revolving credit will indicate what sort of a borrower you are. For borrowers who don’t have a good credit mix or none at all, paying rental and utility bills on time is also considered as credit and included in the most recent scoring models.
New Credit – Every time you apply for credit, the lender will perform a hard credit pull on your credit report at various bureaus. These inquiries though temporary, affect your FICO score by 10%.
A credit report includes borrower personal information (name age, DOB, address), public information (tax liens, bankruptcy, etc.) and all information about your borrowed credit. A free credit report from each of the three main credit bureaus is available once a year at AnnualCreditReport.com. Banks and financial institutions are known to provide free credit scores as a marketing ploy for bringing in new customers.
Sometimes credit reports have errors, and there are a couple of ways to get them corrected. You can either report the error to the credit bureau itself or go directly to the source - the creditor who reported the error in the first place. Getting you errors corrected is very important as it could help raise your score. You can also use rapid rescoring which is a servicing lender provide to make quick fixes to your report. They employ third-party providers who deal with the logistic of getting it done fast.
Knowing how your credit score is broken down and the factors that influence it will help you employ healthy credit habits. Borrowing for only what you need and meeting those timely payments will help ensure you maintain good credit scores and reports perennially. It will also help you secure additional credit for your future financing needs.