How Does a Credit Score Work?

A credit score is a number that is arrived at after an individual’s credit files or reports have been statistically analyzed based on particular criterion that are used to determine that person’s creditworthiness, or the risk involved in extending that person further credit. Unknown to a lot of people is the fact that this score is not only determined by how faithfully you keep to repayment deadlines or fulfill your debt obligations but also how often you successfully apply for credit services and fulfill their obligations.
credit card

Legally, credit bureaus are mandated to collect this information. Companies then involved in extending credit seek this information from credit bureaus and are furnished with it. It is against this information that the decision to extend an individual credit is made.

Credit scores have several functions as a financial tool within an economy, both at micro and macro-economic levels. They help credit and financial institutions decide the credit worthiness of an individual or a firm, and the risk involved in extending them credit, thereby allowing them to make informed, calculated decisions. They also act as a form of control, helping individuals monitor their own credit performance or worthiness while at the same time letting them know that any indiscreet behavior will be noted. Credit scores can also help at a fiscal policy level in determining whether measures and tools in place to govern the credit provision industry are actually effective, or working, and to actually inform fiscal decision makers what credit levels the economy is operating at.

Typically banks and credit card companies use this information but several other firms, like government departments, utility companies, mobile phone companies, landlords and the hotel and leisure industries all source this information from credit bureaus.

The calculation of credit scores varies from bureau to bureau but some general rules of thumb exist, and a typical simplified format is outlined below:

35 – Payment History
30 – Credit to Debt Ratio
15 – Credit History
10 – New Credit
10 – Credit Types in Use

Thus the credit score or credit rating is calculated as a percentage of 100. The break-down above implies that if you excel in one area and lack in another, only fixing the areas which you lack are going to improve your score.

The advantages of having a good credit score are about as obvious as the ones resulting from having a bad credit score. With a good credit score, it is easier to get credit extended to you, at lower interest rates, and with simpler terms. Bad credit scores often imply that requests for credit are either ignored or end up having credit extended at high interest rates with additional built-in costs like insurance and stringent terms to guard against bad debt.

Different scoring systems are used, but in the United States, the most commonly utilized system was designed by a company called the Fair Isaac Company and runs under the acronym FICO; a resultant score derived when using this system is called a FICO score. FICO controls the greatest percentage of the credit score market in the United States and Canada although there are several other competing firms that collectively share a very small percentage of the market as well. In the US, FICO scores range from 300-850, with 723 being a median score as of 2010. This figure reflects the likelihood that a consumer will go 90 days past due or more in the subsequent 24 months after the score has been calculated. The higher the consumer’s score, the less likely he or she will go 90 days past the due date in those subsequent 24 months.

It is important to note that different services recognize different limits of scores below which they are not willing to operate, depending on the economic situation and their own financial situation. The risk, indeed, varies from credit service (mortgage, credit cards) to companies as well.

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