When you apply for credit, whether it is a credit card, car loan, or a mortgage, lenders want to know whether you are likely to repay your loan and make the payments on time. To determine if you are a good credit risk, lenders examine your credit score whenever you apply for credit. Your credit score is a key factor in determining whether creditors will approve your credit application and, if you are approved, the cost of your loan. Other factors that can affect your credit application include your income and employment history.
Your credit score is calculated based on information in your credit report, which is a profile of how you manage your credit (loan) accounts. Your credit report details how many credit accounts you have, how much you owe, the amount of your credit limits, when you opened the credit account, your repayment history (including past due payments, and certain public records (bankruptcy filing or a tax lien). Each of the three national credit bureaus (Experian, Equifax, and TransUnion) maintains a credit report about you.
Your credit report is updated once a month by each of your creditors, who provide information to the three credit bureaus about your loans. Your report is also updated regularly based on any new negative information obtained from public records that indicate an increased credit risk (bankruptcy, lien, or judgment). Consumers with a high credit score are likely to pay back their loans in full and on time, whereas consumers with low scores are likely to carry a considerable risk of default.
The information your creditors provide to the credit bureaus affects your credit score. If a creditor reports that you made a past due payment, it’s likely that your credit score will drop.
Most credit scoring models consider the following factors when calculating your score:
- Payment History
- Amounts Owed
- Types of Credit Used
- Length of Credit History
- New Credit
In calculating your credit score, most credit scoring models assign a higher weight to your payment history and amounts owed than to the other factors. These two factors will, therefore, have a greater effect on your score than the other factors. But it is important to try to do well on all the factors so you can maximize your score.
- At lease once a year review your credit reports from each of the three credit bureaus for inaccuracies and file a dispute immediately if you find an error. To obtain a free annual copy of your credit report, go to www.annualcreditreport.com or call #877-322-8228. Your credit report does not include your credit score.
- Pay your bills on time.
- Keep credit card balances low (30% or lower) relative to credit limits.
- Pay off debt rather than move it around.
- Open new credit accounts only as needed. Having accounts that have been opened a long time increases your credit score.
- Avoid closing credit card accounts because this decreases the average age of your accounts.
- Apply for installment loans (mortgages, car loans) within a 30-day period because most credit scoring models will count multiple inquiries within a brief period of time as only one inquiry.
Maintaining a high credit score is important because this is one of the factors that determine whether your will be approved for credit and the cost of your loan. Applicants with high credit scores typically are offered lower interest rates and better terms and conditions than applicants with lower scores. A low credit score reduces the chances that your loan application will be approved. And if it is approved, you will likely pay a higher interest rate for the loan than a borrower with a higher credit score.
Source: Federal Reserve Bank of Philadelphia