A credit score is a statistical three-digit number ranging from 300-850 that scales an individual’s credit-worthiness and ability to pay debts. A credit rating, often expressed as a letter grade, conveys the credit-worthiness of a business or government. Credit scoring and Credit rating are designed to show creditors a borrower’s likelihood of repaying a loan.
Let’s take for instance in everyday dealings, before lending money to a friend, there are a number of factors that are in play - unwritten rules that the lender has to consider, for instance, does the borrower have a source of income that they could use to pay me back when the time comes; do they have a good history of repaying their debts; are they a person I am in constant contact with; could this possibly change during the duration that we have agreed they should pay back? All these among many other factors.
Similarly, companies and lenders have ways to determine the credit worthiness of their borrowers before they can lend, and credit scores play a key role in a lender’s decision to offer credit.
The Fair Isaac Corporation, also known as FICO, created the standard credit score model which is the most common as of today. There are, however, other providers of credit scoring systems such as insurance and mortgage industries.
Main factors evaluated when calculating a credit score.
- Payment history: Payment of past debts is the most important factor in calculating credit scores and makes up 35% of the total credit score.
- Credit utilization: This is ideally the percentage of available credit that has been borrowed. It makes up 30% of the total credit scores. FICO views borrowers who habitually max out credit cards or who get very close to their credit limits as people who cannot handle debts responsibly.
- Length of credit history: This forms 15% of the total credit score. It is impossible for a person who is new to credit to have a perfect credit score since a longer credit score history provides more information and offers a clearer picture of long-term financial behavior.
- New credit and Credit mix: FICO advises that borrowers only take on new/ extra credit when they must have it or if it makes sense financially. In Credit mix, experts say that repaying a variety of debts indicates the borrower can handle all sorts of credit, according to FICO, borrowers with a good mix of revolving credit and installment loans generally represent less risk for lenders.
How do I improve my credit scores?
- Making consistent timely repayment of past debts.
- Maintain low credit card balances.
- As earlier mentioned, it is impossible for a person who is new to credit to have a perfect credit score. Therefore, to improve credit score, individuals without a history should begin using credit and those with credit should maintain long-standing accounts.
So to get a good score, you mostly need a credit history with no reported late payments as well as low reported balances currently on credit cards.