The Importance of Credit Score: A review on credit score and why banks check it regularly

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:

What is a credit score?

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.

How does a credit score work?

Five main factors are assessed when computing a credit score:

• Payment history: It accounts for 35% of your credit score. It refers to your track record with debts in the past. Late or missed payments in your history would hurt your credit score.
• Credit utilization: It's the percentage of credit available to you that you use. Generally, it’s advisable not to use more than 30% of your credit card's limit. Your credit utilization accounts for 30% of your credit score.
• Length of credit history: As the name indicates, this refers to how long you’ve been using credit. The longer your credit history, the better; Length of credit history accounts for 15% of your credit score.
• Type of credit: It accounts for 10% of your credit score and refers to the mix of credit you use, such as installment and revolving credit.
• New credit: It gets affected by the opening of new credit accounts and applications for new lines of credit. New credit accounts for 10%.

Why is your credit score so important?

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:

• It determines the price you pay for credit. People with bad credit scores have to compensate for the risk of lending money to them by paying higher interest rates.
• It determines how likely your credit applications are to be approved. For instance, you’ll have an easier time getting pre-approved for a mortgage if you have a fair credit score.
• Your credit score also determines how favorable the terms of your credit are. To illustrate, a person with a higher credit would likely receive a higher credit limit on their credit cards.

Managing a bad credit score

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:

• Pay your bills on time. You can use scheduling tools to ensure you never miss a payment. You can also set up automatic payments.
• Regularly use your credit accounts and aim to stay below 30% of your credit limit.
• Avoid carrying debt balance as much as possible. Pay your debt in full if you can.
• Keep your existing credit accounts open, especially the ones with the highest limits.
• Limit how often you open new accounts.

Wrapping Up

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.

Date: 26.10.2022