People take out loans to fulfill various financial goals, like buying a vehicle or a house, higher education, or even a personal loan to repay previous debts.
Low to middle-income families are most likely to take out a loan compared to high-income families. Northwestern Mutual’s 2018 Planning & Progress Study recently found that 68% of the total American population falls in the middle-income category.
But what decides how much loan you are eligible for, or whether at all your loan application will be accepted by the lender? Here’s where the importance of a credit score comes in. Simply put, the borrower’s credit score measures the lender’s risk, and their ability to repay.
Ticket to Borrowing
Companies like Fair Isaac Corporation (FICO - Free Report) , a leading personal credit score provider,
and VantageScore — a joint venture of three leading credit reporting bureaus, Equifax (EFX - Free Report) , Experian (EXPGY - Free Report) and TransUnion (TRU - Free Report) — provide information to organizations to help them manage the risks associated with extending credit to their customers and preventing fraud.
Among them, the most widely used credit score model used by banks and other financial institutions is the FICO score. The generic FICO credit score is between 300 and 850, wherein 300-620 counts as bad, 620-649 as poor, 650-699 as fair, 700-749 as good, and 750 and above as excellent.
Factors That Influence Your Credit Score
There are various aspects based on which the total credit score is given. And if any one of those aspects threatens to bring down your score, one can focus on improving performance in the other factors to bring it back up. Now, let us delve deeper into the factors that form a credit score:
Payment History gets the maximum weightage of 35% in a credit score. Whether you have previously paid your bills on time, how much have you stretched on a late payment, how much time has elapsed from the last time you missed a payment, and whether any of your accounts has been escalated to collection agencies decide most of your credit score. The lesser all the above instances are, the better your score is.
Credit Utilization, or the ratio of debt to available credit, decides 30% of your ultimate score. The other loans or mortgages that you have and the percentage of total available credit that you have used collectively constitute this factor. Again, the lesser, the better.
Credit Age contains 15% of the total weight of a credit score. Preference is given to those who have ably managed previous credit accounts over longer periods of time. Leaving old accounts open can lead to an improved score.
Of the score, 10% is allotted to Credit Diversity, which takes into account the number of credit accounts held by the potential borrower. Carrying different types of credit — auto loans, mortgage, student loans, and credit card —reflects your ability to manage your accounts efficiently.
The final 10% weight is carried by the number of recent hard inquiries that you had. Many in a short time period set off alarm bells for lenders. However, the more loans approved, the better your credit score.
SOS for Low Scorers
Emergencies can crop up anytime. In case you want to apply for a loan but are concerned about a low credit score, focus on significantly improving the two most crucial factors — payment history and credit utilization. However, give at least six months for your corrections to reflect on your score.
Make consistent, on-time payments and you will be on track for a better credit score. A single instance of a late payment can snatch 60 to 110 points. It is also advisable to avoid opening any credit account in the 12 months before applying for an important loan.
Also, as we already know now, the lower your utilization rate, the better your score. Thus, avoiding using too much of your credit card balance will reflect positively on the score card. It is recommended to aim to pull down the utilization rate below 30%.
Your credit score is very important to get loans at the best interest rates, but stressing over each and every factor affecting your score is not the best course of action. Paying your bills on time, using credit cards responsibly, and avoiding unnecessary loan applications will do a great job of keeping your score high.
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