|By: Sha - at January 20, 2013
How Credit Scores Work and Why Credit Scores are Important
An Introduction to Credit Scores
While 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?
A 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.
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
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.
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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