How credit scores are used: for example, to take out a home mortgage.

How Credit Scores Are Used

How Credit Scores Are Used

Understanding how credit scores are used is important for financial and life planning. From applying to credit cards to home mortgages to paying for school, credit scores are used in a wide variety of functions.

Why Are Credit Scores Used

Simply put, lenders want to do business with people who have a history of being responsible with their debt obligations. The three-digit number can affect how lenders do business with you in three main ways:

  • Whether you’re someone they’d like to business with
  • How much it will cost to do so
  • Which options lenders will offer you

Why are credit scores used as opposed to a different way of analyzing responsibility with debt obligations? Here’s a before and after of credit scores:

Before Credit Scores

Lenders used the applicant’s credit report to choose whether to grant credit before credit scores. A lender might have denied credit based on a subjective judgment. This method may have also been time consuming and subject to mistakes.  Lenders may have made decisions based on personal opinion rather than whether the applicant was able to pay back the debt.

The Emergence of Credit Scores

Credit scores started being widely used in the 1980’s. Credit scores help lenders calculate risk more fairly because they’re more consistent and objective. Your credit score simply reflects how likely you would repay debt responsibly, no matter who you are as a person. Credit scores are now dependent upon past credit history in addition to your current credit status.

Credit scoring 101

How is my credit score calculated?

The information that impacts a credit score differs based on which score is used. Overall, your credit score is affected by factors in your credit report including the following:

  • The total number of late payments
  • The severity of the late payments
  • Account age, number, and type
  • Total amount of debt
  • Types and number of recent inquiries

How Your Credit Scores Are Used

If you’re looking into getting credit, the following are some things you should keep in mind:

Applying for Credit Cards

Companies usually look at your credit score as one of many factors in figuring out whether to approve your credit card application. The formula each company uses is a heavily guarded secret.

  • The precise impact of your credit score will depend on which company is reviewing
    your decision
  • Your credit score may allow you to receive additional perks from a credit card company
  • Credit card companies can also use your credit scores to determine credit limits, interest rates, and other credit terms they offer you

Getting loans for school, a car, or a home

Many federal loans don’t look at your credit score. There are still some things to consider.

  • If you apply for a private student loan, however, banks typically are curious about your credit score and credit report history.
  • Your credit report and credit score also affect the loan approval and interest rate of the loan you’ll receive.
  • Auto lenders also look at your credit score to figure out if they will approve a car loan or lease.
  • Credit scores affect the interest rate in addition to the loan length.
  • The requirements for approval are usually stricter for mortgages.
  • Each lender will have their guidelines they’ll follow. However, it’s universal that your credit score is a significant data point that lenders will use.

Because of the latest housing crisis, some lenders may use the credit score as a higher factor in their analysis.

Other Situations

There are other situations where your credit score surprisingly plays a role.

  • Insurance companies are using credit scores to determine whether they want to provide coverage, how much they’ll cover, and how much they’ll charge.
  • This applies to home and auto insurance. When it comes to renting apartments, landlords often use credit scores to determine how much of a security deposit they may want from you.
  • If you need a payment plan to a buy a cellphone, companies may look at your credit score to figure out the type of payment plan options they’ll offer you and whether they’ll want a deposit.
  • Utility companies may take a look at your credit score to determine whether they want a security deposit from you and how much

How Credit Scores Benefit You

Finally, a way to understand how credit scores are used is to see how they benefit you and society as a whole.

Get loans approved more quickly

These days, the majority of credit decisions can be made in a matter of minutes. Credit scores allow department stores, websites, and additional lenders to make credit decisions almost instantly. Mortgage applications can be approved in a short-time frame hours as opposed to weeks.

Get fairer credit decisions

Things like gender, nationality, marital status, race and religion are not used in credit scoring. This allows lenders to be less biased and only focus on the relevant facts related to credit risk.

Credit mistakes are less important

Credit scoring doesn’t negatively impact you forever if you’ve had bad credit previously. More recent on-time payments will be in your credit report, while past credit problems fade away as time passes. Credit scoring takes into account a holistic view of credit-related information. Thus, your overall credit report is a much better view of your risk from the creditor’s perspective. This is in contrast to borrowers turning people down solely on a past problem in their files.

Obtain more credit

Credit scores gives lenders the confidence to offer credit to more people. This is because lenders have a better understanding of the risk they are taking on. Most lenders have their own individual guidelines. So, if you get rejected by one company, you can still get accepted by another. Instead of a simple yes versus no, lenders can offer a choice of credit products for different levels of risk. Credit scores allows lenders to identify more individuals to perform well in the future. This is true despite the fact that their credit report shows past problems.

Get lower overall credit rates

Automatic credit processes, such as credit scoring, allow for credit granting to be more streamlined and cheaper for lenders. The lenders, in turn, charge less for their service downstream to their customers. Lenders also control credit losses using credit scoring. This allows lenders to make rates lower overall. A great example is the fact that interest rates for mortgages are lower in the US compared to Europe. This is at least partially due to the fact that lenders have credit scores available to them.

credit-america

The Average Credit Score in America – And What You Can Learn From It

The Average Credit Score in America – And What You Can Learn From It

In America, the average credit score has gone up a few points, teetering at the edge of 700, according to the latest FICO data. This respectable score is up five points in 2015. While this could the result of a change to the FICO scoring method, it nonetheless offers a chance to review what credit really is, and why taking on debt can help you save money.

Today, while 43% of Americans have a delinquency affecting their credit score, for most of them, that delinquency is 17 months old. What’s more, the average American has used up to 15% of their available credit on things like credit cards, and they have a full six open revolving credit accounts all of which have outstanding balances. Why?

Understanding Credit

As the name suggests, credit is a form of paying it forward. Credit gives you money based on how likely you are to repay that money. For each line of credit you receive, whether it is a loan or a credit card, the interest rate you pay is based on how likely that repayment will be.

Treated as a business, the industry of credit is one that traps people in a race against time. Someone who might, for example, have the earnings to repay a car loan early and have the debt off their shoulders is treated to an early repayment fee. Early repayment fees are a way for companies lending funds to ensure they are still profiting from the loan. This is even if you are timely in your payments. Monthly bills when paid on time for things like a credit card do not acquire any interest. However, when they’re paid even one day late, they’re charged incredibly high fees. Things like mortgage loans have lower interest rates, but because the loaned amount is higher, the total accumulated each month. These loan amounts adds up quickly.

How You Get Scored

The unfortunate thing for many is that without a good credit score, getting reasonable rates for things like a home mortgage or other loans will be quite high. Starting off without any credit history means that in order to earn a good credit score, you have to take on debt, and then slowly, painfully, repay that debt.

Having the funds up front to pay for a lower end car in full earns you next to no credit, which means it does not help your credit score to rise, rather, keeps it steady, unchanging. As such, taking on a line of credit, even if you do not need it, is the only way to earn a higher score. Each month that a debt or line of credit is repaid, it gives you the chance to show that you can be trusted to repay a debt. The more months you repay on time, and the more things you repay each month, the more companies can rely upon you to give them the profits they are seeking with loans and lines of credit.

Increasing Your Score

So, if you have checked out your score for the first time, you might see that without any debt, without any credit checks, and without any credit cards in your name, your score is lower than the national average. In order to bring it up, you have to apply for and secure a debt against you, then slowly repay that debt.

When buying a new car, one way to do that is to pay a large enough down payment that your overall interest rate can be lowered in spite of an average or below average score, then make monthly payments on the rest. Both things work in your credit score’s favor.

Why Improve?

In the case of a credit score, you should not settle for a “fair” report, or whatever figure you have. Reason being, better credit scores save you money long term. Consider that you want to buy a house. If you are getting a thirty year fixed rate mortgage at a rate of $250,000, your credit score translates into direct savings. Consider the charge below:

FICO ScoreAPR (%)Total Interest ($)Difference vs. Top Tier
760-8503.909%$174,966N/A
700-7594.131%$186,499+$11,533
680-6994.308%$195,807+$20,841
660-6794.522%$207,194+$32,228
640-6594.952%$230,503+$55,537
620-6395.498%$260,897+$85,931

DATA SOURCE: MYFICO.COM

Illustrated here, the higher your credit, the more money you save in total interest.

What to take away

What’s important to understand is that you are not alone. No matter what fiscal issue is keeping your score down, even the top score holders have the same issue. In fact, the average “high achiever”, those with a score over 800, have nine open revolving lines of credit. This is three more than average. Given the aforementioned credit information, it makes sense that higher score earners are using more lines of credit and debt to their name. This allows them to make more payments on time, thus cementing the notion that they are “good for the money”.

Most people do not realize that 30% of the FICO score is taken from amounts owed on credit lines. As such, the higher achievers often use just 4% of their available credit. On the other hand, compare this to the 15% for average score holders. While 43% of Americans have a delinquency on their report, 5% of higher achievers do too. Average Americans have 100% of their accounts with an outstanding balance, while higher achievers have but 70%.

Overall, the same fiscal issues are faced by all. The difference is in their impact or severity. Paying bills on time, not using all of the credit you have available to you. In conclusion, not letting accounts get sent to collections all work in tandem will improve your score.