Understanding Credit Scores

Are you confused about how your credit score is formed, here is everything that you should know about your credit score and the various other details related to it.

Updated by Roopsi Gupta on 14th October 2019

A credit score is a three digit score ranging from 300 to 850 which depicts your debt paying capacity. It is formed from so many aspects like the monthly on-time payments, creditworthiness of the borrower all these things combine together which makes a credit report and forms the borrrowers credit score.

Banks and other institutions look for credit score so that they can easily provide loans & credit cards facilities to the customers. A good credit score represents good credit history i.e. the bills are paid on time, the previous loans got cleared and many more.

Table of Contents 

Why do i have different credit scores

Because of the existence of different credit agencies, people have different scores. But the misconception is created that every individual is having one credit score. But that’s not the truth, with agencies using different methodologies, people have slightly differing credit scores which they are not aware about. Also the difference arise in the situation when the lender does not inform about any changes made to all the agencies maintaining that person’s portfolio. 

For the basic understanding of credit score, it is been divided into 2 types 

1- Generic Credit Score- The general credit risk can be determined and used by lenders & bankers to check the general credit risk. A single credit score can be accessed by using the same formula from all three credit reporting agencies.

2- Custom Credit score- The score specifically generated for the individuals from the lenders is known as custom credit score. These reports are formed on individual credit history and other details but it all happens from the portfolio of the lender. Custom credit serves for specific type of lending like auto lending, mortgage lending and few more. 


Credit Reports

The various information an individual gives to the financial intermediaries, institutions, other businesses, credit card companies, banks, mortgages, etc. and the other credit behaviour makes & form the credit report. This set of information also helps in updating the existing information timely. 

The categorization of Credit Report is generally frames on the below mentioned three basis-

1- Credit Inquiries

These are the inquiries done on the request of certain agencies  for the credit information. The inquiry can be ‘hard’ which is done for borrowers who are first time applicants and it can be harmful for them as their credit score can get deducted. This hard inquiry credit score will display in the credit report for the next two years. It can also be done for employment background check or lease rental information apart from getting a credit history report. The inquiry can be ‘soft’ which is definitely not included in the credit report & is done for several other reasons like in case of finding lenders for the borrowers by credit aggregation service agencies, lenders can give a more clear vision to borrowers about the quotes and different terms & conditions of loans. 

2- Credit History

A general record about the debt repaying capacity and the future aspect in repaying the debts is all mentioned in the credit report, this is known as the credit history. Not only it shows about the debt but also about the individual’s accounts in current scene, for how long they are into the picture, credits usage, timely bill payments, credit inquiries done till date, any information on bankruptcies, liens, judgement or any other collection.

3- Public Records & Collection

It is one of the important aspects in the report which tells about if there are any overdues from the borrower’s end, any bankruptcies being done, suits against the borrower, any wage garnishment, etc.. 


Creating Credit Score & their Calculation

The credit scores are created with the help of various tools to identify the amount of risk that the borrower is associated and the debt they can deal with. It is on how often do you make your payments & how many of your accounts are in good standing. The bureaus who make the credit report use either FICO ( formerly known as Fair Isaac Corporation) or VantageScore (combination of three bureaus- Experian, Equifax & TransUnion) along with their own proprietary tools. 

FICO 

FICO was founded in 1989 and widely used by many lenders throughout to generate credit score. In every 100 US lender, 90 of them go with the score of FICO to get the risk assessment done. It is based on so many scoring models but it never reveals its proprietary model & in the general sense it frames the score on five parameters with different levels of importance in forming it up. The five parameters are-

  • payment history (35%)

  • credit utilization (30%)

  • age of credit (15%)

  • credit mix & the amount of credit (10%)

  • credit inquiries (10%)

    Score Rating
    800-850 Exceptional
    740-799 Very Good
    670-739 Good
    580-669 Fair
    300-579 Very Poor

Core Benefits from FICO Score

  • Vision of risk is broad- consolidated picture of the individual’s repay capacity can be driven from it. The best thing in FICO is with time it keeps on updating according to the person’s lending practices and changing behaviour.  
  • Extend Credit- Highly predictive and almost accurate about the customer is one of the nice quality of FICO Score. It can help in making the lender think of increasing the credit line, the extension in credit, etc..
  • Multi-scorecard Design- As the score is combined and framed with so many score cards, it is easy to determine the various risks the person is getting associated with the passage of time.

VANTAGE SCORE 

The Vantage Score was founded in 2006 with the collaboration of 3 main bureaus i.e. Eperion, TransUnion & Equifax. Though it is new to the market but still from the data of  financial year 2016-17 it has provided lending decision by credit score to around 6 billion. There are different versions of Vantage Score that has come with time and updations like VantageScore 4.0 & VantageScore 3.0 (most prevalent). 

It is also based on the same parameters as FICO is with different levels of importance, they are-

  • Payment history (40%)

  • Age and type of credit (21%)

  • Credit utilization (20%)

  • Balance credits (11%)

  • Recent credits (5%)

  • Available credit (3%)

    Score Rating
    750-850 Excellent
    700-749 Good
    650-699 Fair
    600-649 Poor
    300-599 Bad

Consistency with Different Credit Scores

The reason for the collaboration of 3 bureaus to VantageScore was to provide more consistency to the credit scores generated via different models. This model has proven results as it has the feature to add past 24 months credit history to the person’s credit report even involving rent payments and other utility payments, if present that will help better in building credit score.


Factors Impacts the Credit Score 

The Credit Score is based on certain factors, that impacts in building it or making it more or less. Following are the factors that impact the credit score-


1- Credit Card Utilization

It is the ratio which says about the credits an individual uses divided by the total credit limit that person is having. It is also known as Debt-to-Income ratio which is good if it is kept below 30%. If you have a total credit limit of say, $8,000 of two cards and your usage of credits is $2,200, the ratio will be 27.5% which is good to keep and can maintain a good credit score. 

If the ratio goes to more than 30% then if will have a direct & worse impact on the credit score of the individual. 

2- Credit Inquiries

If any agency, bank or any other body is looking after your credit report, the credit inquiry comes in the picture. The report only states about the hard inquiry and impacts your credit score by lowering it down & in case of soft inquiries it does not mention anything. After getting a hard inquiry report, an individual can get their credit score lower for 5 or 10 points for the next two years. 

3- Credit Mix & Number of Accounts in Use

It’s better to have more than one account as credit account as it will increase your credit limit and also it says about an individual’s credit approval from different lenders. This directly improves and increase your credit score. Diversion in having a mix of credit cards will also be beneficial to increase the credit score. Following are the categorization of having a diverse mix of credits-

  • Revolving credits- These are the credits that raise against the credit cards or HELOCs that an individual pay according to how much they use it in  that particular duration. 

  • Installment loans- These are the fixed credits that the individual needs to pay according to the credits raised by them in a particular period of time. 

4- Age of Credit & Established Credit History 

The age of the person’s oldest credit card is known as the age of credit. If mostly all of the payments are done on time without any delays in it, then it can give a very good credit score to the person and also it is always suggested to have your oldest card working if you have all the payments on time. If on any day it will get close your credit history will be minimized and it lowers your  credit score as well.

5- Payment History

Payment history has a direct impact on the credit score of a person. The more on-time payments leads to have a more consistent and good credit score. It helps the lenders a lot in tracking the portfolio of the person but if the person is repetitively missing the payments then the accounts get marked as derogatory and it can lower the score of credit. 

If the payment delays from 30 to 60 days, it does not hinder much but if it happens for 90 days, then the models will re-perform the task and this can damage the respective portfolio & may be the person will not be able to get those desirable rates.


Why Lenders use Credit Score

Previously, the scenario was that the lenders form the credit score manually but the results were not trustworthy on the part of both the parties i.e. the lender and the borrower and also there was no concept of timely updates of the scores with the changes in the lending or credit behaviour of consumers. 

But with the arrival of all the agencies it has become quite easy to check the individual’s report not only about the present credit worthiness but also about the future potential of that person with the help of their credit history. 

Now, lenders can fairly check for the risks as-

  • Credit scores are correct & objective

  • Reflect your repaying capacity in terms of the credit history and present scenario of credit. 


Reasons to Have A Good Credit Score

Though there are more reasons to keep a good credit score but making an effort to have a strong credit worthiness is worth taking for. Here are the reasons to have a good credit score-

Money borrowing matters

The better your credit score is the more you can save while borrowing for your house, car or any education loan or any other kind of loan. For example- if your credit score is around 730 (which is good) & you are to pay mortgage for your house at 4.9% per annum but if the score goes down to 620 then the rate goes to 5.5% per annum. 

It’s about who is keeping your report and who is the one who is going to be your lender. 

Insurance premiums

Some insurance companies ask for the credit score while selling the insurance and if it is the case than you should keep a good score that will improve your creditworthiness and will end up paying less than usual premium for the insurances.

Cable or Internet Connections

With the updating lives, even the DTH connection providers or internet service providers ask for credit score else they ask for the security deposit. If it’s not that good either they deny giving connections or charge higher rates to secure their budgeting but harming yours.

Deal with finances at different verticals

It’s not about just one or two but the overall finance mechanism can be improved if the person is having a good credit score, it’s good in the long term vision you can be saved from so many future hardships. 


Repairing a Poor Credit Score

If the person is having a poor credit score, there are a few things to keep in mind and improve the credit score. Following are the points to remember for this- 

  • The payments should be made on time as it covers the major part while forming the credit report. The more time payments will be visible the more good it will be for the person to have a decent credit score. 

  • There is a provision that the hard enquiries appears in the report for around 2 years like they are considered as there for one year but keep on having a track about more timely things than having delayed stuff in it so that you can easily remove the hard inquiry thing from the report and make a level up in your credit report.

  • A foreclosure appears in the report for the next 7 years though it can’t be removed from the report but what is the best that can come to the picture timely payments, increasing your debt payments, lowering the debts that will increase the score and you can get more weightage towards these things.

  • As the liens are shown in the credit report it’s better to either pay your taxes on time and if it is not done than just make an application to the government to remove the lien from the report after clearing the tax liens so that the score can get upgrade. 

  • Bankruptcy is the major and challenging thing to recover from. Its like if you are able to do so that’s really good. A secured card can help you with making a sound credit report after bankruptcy but choose the secured card wisely so that it will help you increase.


Conclusion 

The bottom line is may be your credit score vary with respect to numerous agencies available in the market but one should always keep a check on the credit report that is behind the credit score. From there the points of improvement can be picked and worked upon. Keep on monitoring the report can make your report go higher or can determine the reasons for its drop.