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Credit scores are essential for investments, loans, and housing but how are they calculated? Why are there multiple entities who report different scores for the same person? Keep reading to find out more about the science of credit scores, why the matter, and why bankruptcy affects your score.
What Is a Credit Score?
Credit
To understand credit scores, it is important to understand credit. Credit is a system where a lender gives a borrower with the understanding that it will be paid back in full at a later date. It is important to note that lenders may approve or deny applications for credit based on the creditworthiness of the borrower.
Creditworthiness is an indicator that a borrower is highly likely to pay back their balances on time. High risk borrowers may be more likely to accrue high balances and may not pay back their balances on time or at all and could default on the loan through bankruptcy.
Credit Scores
A credit score is a number that denotes the creditworthiness of a borrower. Scores typically range from 300-850 with higher numbers denoting more creditworthiness whereas low scores are a sign that a borrower may be high risk.
Credit scores are evaluated by three major credit bureaus including:
- Experian
- Equifax
- TransUnion
The credit score model was created by the Fair Isaac Corp. or FICO and is the most commonly used scoring system.
Function
As mentioned previously, credit scores are a measure of creditworthiness. They determine whether a borrower is subprime or high risk. Based on this valuation, lenders may decide to approve or deny a loan or credit card application. Credit scores can also impact interest rates.
In many cases, interest rates are competitive meaning borrowers can compare interest rates and choose the lowest option. If a borrower has a higher credit score, they may have more options whereas “subprime” borrowers could have only a few options if any.
Credit scores impact many things from mortgages to credit cars and auto loans. It is also important to note that private loan companies, who often handle student loans, also recognize credit scores, and can refuse to give a line of credit if a borrower’s score is too low.
In general, credit ranges are categorized as follows:
- Excellent Score: 800-850
- Very Good Score: 740-799
- Good Score: 670-739
- Fair: 580-669
- Poor: 300-579
Credit scores also affect the amount required for deposits to obtain smartphones, utilities, cable service, or renting an apartment.
How Scores are Calculated
The most confusing part of credit scores is how they are calculated. These scores have tremendous impact on an individual’s financial future, but the factors that make up a credit score are based on everyday choices.
In general, across all major credit bureaus credit scores are based on:
- Payment History: Timely payments or missed payments over the course of a loan period
- Length of Credit History: How long a borrower has had a line of credit
- Total Balance/Credit Utilization: The total amount of credit owed across all accounts
- Types of Credit: Mortgages, credit cards, student loans, etc.
- New Credit: How many new lines of credit were approved in recent years
Payment history accounts for at least 35% of a credit score as it shows whether the individual is capable of paying their bills on time. The total balance is at least 30% of the score and is evidence of how much credit the borrower has used out of their credit available.
Most credit reporting agencies recommend that borrowers not use more than 30-50% of their total line of credit. For example, if a borrower uses a credit card with a $10,000 limit it is recommended that they not accrue more than $3,000 of debt on that card.
The other credit factors like the diversification of credit and new credit typically account for 10% of the total score. It is important to note that credit inquiries may impact a borrower’s score. Credit inquiries typically occur when a significant purchase is made. Banks will make a “hard” inquiry before approving a mortgage. Hard inquiries have at least a two to five point impact on credit scores whereas a “soft” inquiry has no impact. Lenders will typically warn borrowers of a hard inquiry before they proceed.
Takeaway
A credit score is a number ranging from 300-850 that indicates an individual’s creditworthiness. The score is based on a number of factors from payment history and types of credit to credit utilization. Generally, a good score is between 670-739 while a great score is between 740-850. The higher the score, the more options and better loan terms are available to the borrower. Credit bureaus like Experian and TransUnion are responsible for calculating scores and have trackers available for borrowers to monitor their financial position.
Credit scores are incredibly important, but little things can have a very negative impact. If a borrower faces hardship, unexpected costs, or other unforeseen circumstances, they could be stuck with a low credit score and few options for relief.
However, there are many debt relief options available. If you feel like you are drowning in debt, contact the Law Office of Seni Popat, P.C. You have legal options, and our attorney can help.