Ever wonder why you can go online and be approved for loan within 60 seconds? Or get pre-qualified for a car without anyone even asking you how much money you make? Or why you get one interest rate on loans, while your neighbor gets another? The answer is credit scoring. Your credit score is a number generated by a mathematical algorithm — a formula — based on information in your credit report, compared to information on tens of millions of other people. The resulting number is a highly accurate prediction of how likely you are to pay your bills. If it sounds arcane and unimportant, you couldn’t be more wrong. Credit scores are used extensively, and if you’ve gotten a mortgage, a car loan, a credit card or auto insurance, the rate you received was directly related to your credit score. The higher the number, the better you look to lenders. People with the highest scores get the lowest interest rates. Lenders can use one of many different credit-scoring models to determine if you are creditworthy. Different models can produce different scores. However, lenders use some scoring models more than others. The FICO score is one such popular scoring method. Its scale runs from 300 to 850. The vast majority of people will have scores between 600 and 800. A score of 720 or higher will get you the most favorable interest rates on a loan, according to data from Fair Isaac Corp., a California-based company that developed the first credit score as well as the FICO score. Currently, each of the three major credit bureaus uses their own version of the FICO scoring method — Equifax has the BEACON score, Experian has the Experian/Fair Isaac Risk Model and TransUnion has the EMPIRICA score. The three versions can come up with varying scores because they use different algorithms. (Variance can also occur because of differences in data contained in different credit reports.)

No matter which scoring model lenders use, it pays to have a great credit score. Your credit score affects whether you get loans or not, and how high your interest rate will be. A better score can lower your interest rate. The difference in the interest rates offered to a person with a score of 520 and a person with a 720 score is 4.36%, according to Fair Isaac’s Web site. On a $100,000, 30-year mortgage, that difference would cost more than $110,325 extra in interest charges, according to http://Bankrate.com’s mortgage calculator. The difference in the monthly payment alone would be about $307. If you rented an apartment, got braces, bought cell phone service, applied for a job that involved handling a lot of money, or needed to get utilities connected, there’s a good chance your score was pulled. If you have an existing credit card, the issuer is likely to look at your credit score to decide whether to increase your credit line — or charge you a higher interest rate, according to a credit scoring study by the Consumer Federation of America and the National Credit Reporting Association. There are three ways a loan affects one’s credit score. A loan is money that’s been given from one person (the lender) to another (the borrower) with a promise to repay. When you borrow a loan, you typically sign a contract agreeing to make a certain number of payments for a certain amount by a particular date each month. In a broad sense, credit is the trust or belief that you’ll repay the money you borrow. You’re said to have good credit when lenders believe you’ll repay your debts and other financial obligations on time. However, bad credit indicates you’re not likely to pay your bills on time. Your payments on a loan and even borrowing the loan itself has an impact on your credit, more specifically, your credit score which is the numeric snapshot of your credit history at a given point in time.

First, applying for a loan personal credit can lower your credit score by a few points. That’s because 10% of your credit score comes from the number of credit-based applications you make. Each time you apply for credit, an inquiry is placed on your credit report showing that a lender has reviewed your credit report. Several inquiries may indicate that you’re desperate for a loan or that you’re taking on more loan debt than you can handle. If you’re shopping for a mortgage loan or auto loan, you have a grace period during which those loan inquiries don’t affect your credit score. Even after you’re done rate shopping, the loan inquiries are treated as a single application rather than several. Second, timely loan payments raise credit scores. Your loan payments will have a significant impact on your credit. When it comes to your credit score, payment history is 35% of your credit score. That’s more than any other credit score factor. Timely loan payments will help improve your credit score, making you a more attractive borrower. However, late loan payments will damage your credit score. Defaulting on your loan can result in serious credit marks like repossession and foreclosure. Third, high loan balances may harm credit. The balance of your loan influences your credit. You’ll gain credit score points as you pay your balance down. The larger the gap between your original loan amount and your current loan balance, the better your credit score will be. While your loans and your debt-to-income ratio is not included in the credit score that’s sold by FICO and the credit bureaus. But, many lenders consider income a factor in your ability to repay a loan, so their proprietary credit scores may use your debt-to-income ratio as a credit consideration. Your debt-to-income ratio compares all your loans and credit cards to your total income. A high debt-to-income ratio could raise your risk score with the lender and get you denied for loans.

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Category: Finances
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