Have you ever wondered what a good credit score is? People usually encounter it when taking out loans, but few actually understand it well.
Having a good credit rating is a crucial component of sound personal finance. Understand the various credit scoring models and the several methods that may boost scores for each.
Table of Contents
What is a Credit Score?
A credit bureau gauges how reliably people can pay debts back by assigning a credit score. They analyze a person’s credit report then assign a corresponding three-digit number. Typically, punctual diligent payments net a good high rating.
On the other hand, people receive low or bad credit if they accumulate excessive unpaid balances.
Why Are Credit Scores Important?
A credit rating measures the status of someone’s personal finances. Good to excellent credit scores indicate that a person can pay debts on time, so they have good money management. In contrast, bad credit means they fail to make diligent payments on numerous debts.
A person may not be earning enough to complete monthly payments, so this behavior reflects poorly on their credit rating.
This number informs certain institutions, helping them in providing their services. Most notably, lenders offer loan terms and conditions depending on a client’s rating. After all, they always want diligent and punctual payment, and those with good credit are more likely to repay on time. As a result, they get the best offers, but others receive the worst loans, if at all.
Credit scores are crucial in gaining access to various essential goods and services. For example, it helps people purchase a new cell phone with favorable payment terms. In fact, employers assess credit rating in deliberating job applications. A good credit score may indicate that an applicant’s productivity won’t be hindered by financial problems.
Credit Scoring Systems
Credit bureaus assign scores based on their specific rating systems. Lenders may prefer certain ones, so people must understand the ones their creditors use. We will discuss the most popular ones: FICO score and VantageScore.
However, we remind that there are other credit scoring models and bureaus may release updated versions.
The FICO (Fair Isaac Corporation) Score has been a staple for credit unions and banks since 1989. It’s the mainstay system with a scoring range from 300 to 850. The system has seen many iterations, the latest one being the FICO 9 released in 2014.
Nevertheless, FICO scores comprise a variety of factors, so understanding each can help people improve their ratings.
The largest aspect of FICO scores is payment history as it occupies 35% of the rating. On-time payments add to this scoring component while late ones subtract from it. As balances stay longer in your credit history, their corresponding deductions increase. As a result, repaying bills on-time is vital to maintaining a good credit rating.
The second crucial part of FICO scores is credit utilization, the ratio of one’s credit use, and their credit limit. It must never exceed 30% or a person risks reducing their score.
Payment history and credit utilization are usually focused on most credit scoring models. That’s why maintaining both is often necessary for a good credit score.
Additionally, credit history makes up 15% of peoples’ FICO ratings. It is measured by how long a person has owned credit cards, and FICO scores rise the longer that duration becomes. The number of credit cards an individual owns is called credit use, and it is 10% of the FICO rating.
Lastly, new credit is the remaining 10%, and it lowers as a person borrows more credit.
As we’ve mentioned, credit bureaus release new versions of their rating models such as the upcoming FICO 10. Most credit institutions still use older versions, but they may switch to this updated iteration soon.
It would still use the five conventional factors, but the revised model will penalize late payments even more. Thus, it will become even more important to maintain payment history and credit utilization.
The major credit unions wanted to create competition for the FICO score, so they formulated the VantageScore in 2006. Since it’s relatively new, only a few financial institutions use this model.
Still, it is composed of factors similar to those used by its older counterpart. Consumers should still make on-time payments and reduce credit utilization to earn excellent credit.
Payment history also dominates the VantageScore, but it only takes up 32% of the rating. The second greatest factor in a good credit score is still credit utilization at 23%.
The next ones in descending order are credit balances and credit history length and depth at 15% and 13% respectively. Lastly, 10% consists of a person’s recently opened credit accounts and 7% is their available credit.
People may prefer the VantageScore over FICO since it only considers one month of their credit history. Those opening new lines of credit with the former won’t need to worry about older debts disqualifying them.
On the other hand, FICO scores are derived from six months of credit history that may grant lower ratings. Nevertheless, this illustrates why understanding scoring model differences is important.
This characteristic of the VantageScore rating system may soon disappear due to the recent version. VantageScore 3.0 has been the staple then, but VantageScore 4.0 may soon take over. It uses new technologies such as machine learning to use trended credit data in scoring.
It may not favor those opening new lines of credit once it becomes mainstream.
How to Improve Credit Score
There are many ways credit scores may be improved and built by helping with debt payoff. For instance, debt consolidation replaces multiple debts with a larger one with a lower interest rate.
Alternatively, credit counseling teaches better money habits and may assist further in using debt management plans.
For credit card balances and other unsecured debts, debt consolidation may help in paying your bills. It may be done using a credit card or loan, and it will replace several debts with one. This may help people pay their debts quicker and easier as they only focus on just one deferred payment. However, approval odds still depend on credit score, so other methods may better suit those with bad credit.
Credit counseling companies guide people in managing their personal finances. They meet with clients and discuss their money problems, then they recommend possible solutions. Their credit counselor will teach positive financial habits and may refer clients to helpful seminars.
In some cases, they form debt management plans that lower their client’s monthly payments.