Many of us know the importance of a good credit rating. It gives people a few options with their finances that they might not otherwise have if they have a bad score. But few actually can tell what it is and how to come by or how to calculate it. So here are some things that you may need to know about credit scores.
Most credit scoring is based on the model created by the Fair Isaac Corporation. Because of this, it is known as the FICO model, and a lot of today’s financial institution makes use of it. This is not to say that there aren’t any other credit score models out there but suffice it to say that the FICO model is the most commonly used.
A credit score is a three-digit statistical number based on evaluations of an entity’s credit history. That number ranges from a low of 300 to a high of 850. The closer this number is to 850, the higher the credit score is. A person with a good credit rating is said to be “credit-worthy” and has more options financially than others with lower scores. This essentially means that an individual or entity has a high probability or capacity of repaying a loan or debt.
But why aim for a high credit score? A high rating ensures that when you take out a loan, you will have a smaller interest relative to others with a lower score. For example, for entities with FICO scores of 760 to 850, the interest rate for a loan is 3.3% while those with a score ranging from 700 to 759 have an interest rate of 3.5%. This means that the mean monthly or quarterly payment for that loan is significantly lower if your rating is high. The rationale is that one has a high probability of debt repayment so even if it takes a bit longer, the lender will receive all the money he is owed by the lender. -So applying this to real situations, the higher your credit score, you have lower interest rates and will pay less money over time for debts owed.
Your credit score is calculated using certain variables, the number of which depends on the model used. Most use debt ratio, credit type, credit length, credit inquiries, and payment history. The debt ratio is the amount of your revolving credit relative to the amount of available credit and comprises 30% of your score. A good example is using credit cards. Having a credit limit of $5000 on a card with a current balance of $2500 gives you a debt ratio of 50%.
Credit types comprise 10% of your score and are based on the credit listed on your report, including revolving credit, installment, and mortgage loans. Asking for new credit is part of credit inquiries and makes up 10% of credit ratings. The length of time that you have credit on your report also constitutes 10% of your score.
The most sizable of these is payment history. This includes payments and collections. It also includes tax liens and bankruptcy claims. Each account will be on your report for a specific time and will hurt your credit score in its distinct way.
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