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 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.
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.