Credit Score

A Credit Score is something we have been hearing or rather we hear all the time. In the US Banks talk about your credit score when you go to get a loan. Right from getting a loan to getting a job, your credit score is something that is checked. Even in India private banks and lending institutions have started checking the credit history of a customer before entering into a loan agreement with him. So, it is imperative that we learn what a credit score is and how we can build it.

What is a credit score?

A credit score is a number that lenders use to estimate risk. Experience has shown them that borrowers with higher credit scores are less likely to default on a loan. Usually banks and lending institutions would prefer somebody with a good credit score than someone who does not have such a strong credit score.

How are credit scores calculated?

Credit scores are generated by plugging the data from your credit report into software that analyzes it and cranks out a number. The three major credit reporting agencies don't necessarily use the same scoring software, so don't be surprised if you discover that the credit scores they generate for you are different. Generally lesser your outstanding debt and better the pay check you receive every month, it is better for your credit score. For ex: let us say A & B draw a salary of Rs. 50,000/- every month. A has a home loan for which he pays an EMI of Rs. 20,000/- every month whereas B does not have any such loans. So, obviosly the credit score of person A would be better than that of B and he would stand a better chance of striking a better deal or a loan from any bank or financial institutions.

Which parts of a credit history are most important?

There are many aspects of your credit history that affect your credit score.

35% - Your Payment History - Credit cards, Telephone bills and other utility bills
30% - Amounts You Owe - Outstanding credit amounts in loans and credit cards
15% - Length of Your Credit History
10% - Types of Credit Used
10% - New Credit

Why is your credit score important?

The credit score of an individual is an indicator of how worthy he is as a borrower to receive a financial product from a bank. A loan is a commitment on the part of the borrower or the customer to repay the loan. So, a bank would prefer a customer who has a better chance of repaying the loan than someone who has a past of being irregular or delinquent in his payments.

Most customers with decent credit scores manage to get a loan or any other service from a bank but at a price. Let us take the same example as above A & B. The rate of interest at which person B gets any new loan would be lesser than person A. This is because person A has a lesser credit score and hence the bank would want to collect as much money as possible from B before he stops making payments. If A manages to pay off his loan properly, this would eventually improve his credit score.

Credit scoring software only considers items on your credit report. Lenders typically look at other factors that aren't included in the report, such as income, employment history and the type of credit you are seeking.

What's a Good Credit Score?

Credit scores (usually) range from 340 to 850. The higher your score, the less risk a lender believes you will be. As your score climbs, the interest rate you are offered will probably decline.

Borrowers with a credit score over 700 are typically offered more financing options and better interest rates, but don't be discouraged if your scores are lower, because banks service nearly everyone.

It is believed that only around 10% of the population has a credit score of over 800. The bulk of the customers who receive services from banks and financial institutions are in the 550 - 700 score range. Anyone who has a score of over 700 can easily get services from banks without much of a hassle.

How to Improve your Credit Score

Your credit score is one of the most important indicators of your financial strengh and profile. The better your credit score, the better would be the services offered to you by service providers.

There are some simple steps that we can take towards improving our credit score.

Lenders analyze your credit scores to determine whether or not to approve a home mortage, a car purchase and nearly all other types of loans.
Before lending you money, creditors want to determine how much of a risk you are in other words, how likely you are to repay the money they loan you. Credit scores help them do that, and the higher your score, the less risk they feel you'll be.

Most increases to your credit scores take place over time and require an ongoing effort from you. The only true credit score quick-fixes are to pay down debt and to successfully dispute negative information on a credit report.

Credit scoring software looks at five areas of your credit reports:
Your Payment History
Amounts You Owe
Length of Your Credit History
Types of Credit Used
Your New Credit

The article How Your Credit Score is Calculated explains what's included in each of the five categories. You can improve your credit scores by taking a close look at your credit reports and charting a plan of action to improve them.

Some main items you can focus and address are:

1. Improve your Payment History
2. Keep Debt to a Minimum
3. Length of Your Credit History
4. Manage New Credit Wisely
5. The Types of Credit You Use


Improve Your Payment History
1. Always pay your bills on time. Late payments play a major role in driving down your score.
2. Contact your creditors as soon as you know you will have a problem paying bills on time. Try to work out a payment arrangement and negotiate with them to keep at least a portion of the late notations off of your credit reports.
3. If your situation is serious, see a legitimate, non profit credit counselor. Avoid the scam artists who promise a quick reversal of your credit problems.

Keep Debt to a Minimum
1. Keep your credit card balances low. High debt-to-credit-limit ratios drive your scores down.
2. Pay off debt, don't move it around. Owing the same amounts, but having fewer open accounts, can lower your score if you max out the accounts involved.
3. Don't close unused accounts, because zero balance might help your score.
4. Don't open new accounts that you don't need as a quickie approach to altering your debt-to-credit-limit ratios. That can lower your score.

Length of Your Credit History
1. Time is the only thing that can improve this aspect of your scores, but you can manage it wisely
2. Don't open several new accounts in a short period, especially if your credit history is less than three years. Adding accounts too rapidly sends up a red flag that you might not be able to handle your credit responsibly.

Manage New Credit Wisely
1. Several credit inquiries during a short period means you are attempting to open multiple new accounts, and that lowers your credit scores.
2. Credit scoring software usually recognizes when you are shopping for a single loan within a short period of time, such as a home loan. If multiple inquiries are necessary, have them pulled as closely together as possible.
3. Do try to open a few new accounts if you've had credit problems in the past. Pay them on time and don't max out your credit limits.

The Types of Credit You Use
1. A mixture of credit cards and installment loans, loans with fixed payments, can help raise your score if you manage the credit cards responsibly.
2. Having many loans can lower your scores since payments remain the same until balances are paid in full.
3. Don't open new accounts just to have several accounts or to attempt a better mix of credit.
4. Closing an account doesn't remove it from your report. It may still be considered for scoring purposes.