We’ve all heard of credit scores. But what are they? How do lenders use credit scores?
Your credit score is a number based on a formula using the information in your credit report. The result is an accurate forecast of how likely you are to pay your bills.
Credit scores are widely used. If you’ve gotten a loan, a credit card, or even auto insurance, the rate you paid was directly related to your credit score. The higher the score, the better you look to lenders. People with the highest scores get the lowest interest rates.
Defining Credit Risk
Credit scores look at information that can predict your future behavior. If you have been paying your bills on time for the past 25 years, you're likely a low-risk person to lend to, In contrast, imagine you got your first credit card two years ago and have had four late payments during that time. Your balance on the card is at the credit limit. You have applied for new credit four times in the last six months. Based on these facts, you will have a lower score, and are considered a higher risk.
Most lenders in the United States use the FICO credit scoring system. This system gives weight to different parts of the credit report. Recent payment history carries more weight than applying for credit.
Why Lenders Use Credit Scores
Before credit scores, lenders looked directly at your credit report. A lender may have denied credit based on a biased judgement. This method was also time-consuming. Lenders used personal opinions to make a decision about an applicant that had nothing to do with their ability to repay the loan.
Today, credit scores assess risk more fairly because they are consistent and objective. Consumers also benefit. No matter who you are, your credit score reflects only your likelihood to repay debt.
Understanding Credit Scores
What are the credit score factors?
- Your total debt
- Types of accounts
- How many accounts you have open
- Number of late payments
- Age of Accounts
Understanding these factors is key to improving your credit score. The factors help you to improve credit history to become low risk.
Credit scores can and do change. Often, a negative item on a credit report can result in a quick and sudden decrease in the score. However, improving a credit score usually takes time and patience. There is no "quick fix" for damaged credit.
Information brought to you by our partner, Greenpath Financial Wellness