Personal Finance

Money - Personal Finance
By: - at January 20, 2013

How Credit Scores Work and Why Credit Scores are Important

An Introduction to Credit Scores
Credit ScoreWhile an increasing number of people turning to different kinds of lenders to establish credit, a great number of these people and others still have difficulty understanding how credit scores work and why credit scores are important.  In truth, credit scores are the most important way banks and other lenders calculate risk.  All or most lenders have a risk assessment department that assesses the risks involved when lending money to you.  Most of those lenders will use your credit scores on their credit file or report.  You might be wondering how these lenders collect information about you and how they calculate credit scores.  First of all, you need to know that these lenders do not have information about you on their credit file; rather they use third party services providers to collect information about you to help make a decision whether or not to lend to you.

What are Credit Rating Bureaus or Agencies?
These third party services provide information about you to the lenders and are called credit rating bureaus.  They are independent organizations that keep all kinds of information about you that relates to your financial circumstances.  Lending agencies such as banks, insurance companies, leasing companies, building societies, credit card issuers and all other financial products providers rely on these credit rating bureaus to get information about you so that they can asses your credit risk.  There are 3 major credit rating bureaus: Experian, TransUnion, and Equifax.  These credit rating agencies are responsible for collecting information about you, and based on the information they award you points that form your overall credit scores.

When you apply for credit in any form be it a credit card, overdraft protection for a bank account, a car loan, a home loan, or a store card the lender will run a credit check to see if you qualify.  The lenders will also use the credit scores to determine the amount of credit or loan you might get.  So both fundamentally and technically credit scores are the single most important factor in deciding whether or not you will get credit from the lender.  So it is important for you to know how credit scores work and why credit scores are important.

What is a Credit Score?
Credit ReportA credit score is just a number calculated by credit rating agencies based on the credit history or information they have on their file about you.  Lenders such as banks or credit cards issuing companies use this number to determine your suitability to obtain a loan or credit.  If the score is good then most likely lenders will approve your request.  If you do not meet their approval guidelines they might just turn down your application for credit.  It is important to note that banks and other lenders do not calculate your credit score but credit rating agencies do.  But many lenders might use their own credit scoring methods by taking in to account your monthly income, the length of your employment, and other information is used when processing your loan application.  But most lenders rely on the credit scores solely provided by the credit rating agencies to make a decision when it comes to offering any credit.

How Lenders use Credit Scores?
Credit rating agencies continually update your credit scores based on changes to your information.  When you apply for a loan from a bank, the bank looks at your credit scores and then compares the scores of other applicants who obtained a loan.  If those customers have maintained good records of making the repayments on time, then the lenders might predict how likely you will pay the borrowed money back based on the similarities in your application.  Therefore, by comparing your scores to those with the same scores the bank can predict how much risk is involved with new applicants that have certain credit scores.

How Credit Scores Work and Calculated?
All these 3 credit rating agencies use FICO (which is the acronym of Fair Isaac and Company) scores that they provide to the lending agencies to help them get a clear picture about your financial conditions and credit history.  Most lenders use FICO scores to assess the risk factors when processing a loan application.  Experian, Equifax, and TransUnion worked with FICO and discovered a credit scoring method called FICO scores.  Most lenders still use FICO scores to determine the risks when loaning out money to any applicant.

Good Credit ScoreEach of the credit rating agencies collects information about you and keeps it in a file.  These credit rating bureaus use your residence and work addresses, borrowing history,  and criminal records  from various sources.  For example, if you took a bank loan last year but made many late payments then the lender might have reported this to the credit rating agencies.  For each missed or late payment, these credit rating bureaus will deduct points from your existing scores.

Each score you obtain depends on the information the credit rating bureaus have on their file about you.  If this information changes your credit scores will also change for the better or worse.  For example if you have made payments for all of your existing credit cards on time for the last six months you will be awarded certain points, which will change your overall credit score.  If you are a good borrower your credit score will improve or increase.  If you are struggling to manage your finances and missed a payment or made a few late payments, it will have an adverse impact on your credit scores.  That is why it is essential to know how credit scores work and why credit scores are important to obtain credit or loans.

Conclusion
Today, it is quite difficult and almost impossible really to obtain a loan without good credit scores.  It is essential that you check your FICO scores or credit scores from time to time and especially before you apply for a new loan or line of credit. Credit scores are considered a very fair method by most lenders.  You should make sure that you pay all your bills on time and make payments for your credit cards or loans on time.  Keep your credit card balance low and get rid of all your unused credit cards to boost your credit scores.


 

 

 

 

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