For many, securing credit is the primary way of financing purchases. People use loans for many purposes, from funding emergencies to buying homes or vehicles. However, credit is not readily available to everyone. Lenders pay attention to the creditworthiness of individuals seeking to borrow. That's necessary to safeguard against the risk of default.
Since lenders constantly had to evaluate people's creditworthiness, credit scores emerged as a convenient tool. Credit score remains a misunderstood concept by many. Not to worry, here, we will break down what credit score is, why it's important and how it works. Let's dive right in:
A credit score is a three-digit number representing a prediction of your credit behavior. Essentially, it depicts your likeliness to repay the loans you take. Your credit score is generally computed based on information contained in your credit reports. Banks and other companies use this number to determine whether to offer you credit products such as auto loans, mortgages, credit cards, etc. Your credit score also generally determines the interest rates attached to your loans.
Notably, a credit score generally lies between 300 and 850. It's mainly calculated using a credit score model created by Fair Isaac Corp., known as FICO.
The information is collected, analyzed, and disbursed by bodies known as credit bureaus. Typically only three major national credit bureaus exist. These are Equifax, Experian, and TransUnion.
Five main factors are assessed when computing a credit score:
As we have already discussed, your credit score is simply a reflection of your perceived creditworthiness. Thus for lenders, credit scores are really about mitigating risk as much as possible. It's bad business for a bank or any other lender to lend money to someone who does not make repayments on time or at all. In such a case, the bank would end up bearing the cost of the default.
To avoid this situation, lenders look at a prospective borrower's credit score, which sums up their credit behavior. This score helps the lender decide what amount and form of a credit to offer. This way, banks and other lenders can filter prospects that are likely to pay it back.
Your credit score is not only important for the bank but also for you. Since your credit score reflects your creditworthiness, it determines your access to credit. Here are some of the crucial ways your credit score is essential for you:
While a low credit score will affect your access to credit, it doesn't mean you can't get loans. There are loans with no credit check that you can leverage. However, if you want to improve your credit score, here are some steps you can take:
Credit scores are essential. They can either save or cost substantial amounts of money. So it's necessary to pay attention to your credit score and adopt habits that help improve it.