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Credit Score – How is it works?

We’ve all seen the commercials offering free credit reports and services to improve your credit score, and in today’s modern economy, your ability to enjoy a good quality of life is directly tied to your ability to secure credit. But what do those numbers actually mean? Who determines your credit score, and how does it affect you?

The most commonly used credit score is the FICO. This rating system was first developed in the late 1950s by Fair Isaac and Company, today known as the Fair Isaac Corporation. The FICO score is determined through a set of statistics derived from things like payment history, previous uses of credit such as loans or charge accounts, and types of credit used, like mortgages and installment loans.

The FICO score gives banks and other financial institutions a ‘snapshot’ look at someone’s credit history to help assess their risk as a borrower. If you have a good score, lenders compete for your business in the form of lower interest rates and better payment terms. If you have a poor score, you will face stiff interest rates and in many cases have difficulty obtaining credit.

What determines your score?

Your FICO score is based on the following percentages-

  • 35% Payment history- do you pay bills on time, or do you have a history of late payments?
  • 30% Credit utilization- this is the ratio of your debt compared to your total available credit
  • 15% Credit history- the length of time that you have been establishing credit in your own name
  • 10% Types of credit- successfully managing different forms of credit (consumer finance, mortgage) will improve your score
  • 10% Recent credit search history- multiple credit applications and checks can be an indicator of financial hardship and can contribute to a decline in credit rating. Credit checks initiated by you, your employer, or by a company offering pre-approved credit do not impact your FICO score.

FICO Score ranges and what they mean

  • 800 and up- Excellent- Your score makes you extremely attractive to lenders, and you have no problem securing credit at the lowest available interest and annual percentage rates. Maintaining a score at this level means using a significant amount of monthly credit and paying it off in advance.
  • 700-799- Very Good- Just over 25% of the Unites States enjoys a credit score in this range. You are disciplined with your finances and are able to secure credit from just about any institution at competitive rates.
  • 680-699- Good- At this range you are able to get approved easily for loans and credit, but you will be paying a higher interest rate than you would at a higher score. If you are considering a long term obligation like a mortgage, you may want to boost your score or you’ll pay more over the life of the loan.
  • 620-679- Okay to Fair- You are able to get financing when you need it, but you’ll be paying more for it and have less options. The good news is you can bring up your score to a more attractive level without too much difficulty.
  • 580-619- Poor- With a FICO score of Poor, you may be able to obtain unsecured personal loans and certain mortgages, but you’ll be paying top dollar in interest rates and other fees. In this range you should be actively working to improve your score.
  • 500-570- Bad- If you qualify for any loans, they will be small and at maximum interest levels. Debt consolidation and personal bankruptcy may be looming without careful action.
  • 499 and lower- Very Bad- You will need professional help to repair your credit and get a handle on your finances. By working with a credit counselor you will be able to dig out, but it will take time and discipline.

Certainly a FICO score doesn’t tell the full story of a person’s ability to repay a loan, but from the perspective of a financial institution it’s a quick and accurate risk assessment, and remains widely used. When you maintain a good score, you maximize your credit options and enjoy a substantial savings in interest and other fees.

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