Understanding Your Credit Score

You probably wouldn’t loan money to a friend if you know that she rarely pays off her debts, right? The same logic applies when a lender decides whether or not to loan money to you for a car, a home or another big purchase. This is exactly why your credit score is so important—this one simple number can make or break your plans to move into a new home or replace your broken down car.

One little number, one huge impact
When you apply for any type of credit, whether it’s a credit card, a mortgage or a car loan, lenders want to calculate the risk they would take by lending money to you. They use your credit score to determine that risk.

Your credit score represents your financial history based on information gathered from companies that have given credit to you. This number is calculated based on your payment history, amounts owed, length of credit history, new credit and types of credit used. The higher your score, the lower the risk you are to lenders. Therefore, if you have a high credit score, lenders are more likely to offer you a lower interest rate, especially on home loans.

Keeping score
You credit score is mostly affected by your credit and debt ratio. Beacon scores range from 400 and 844, while FICO scores range between 350 and 880. Typically, a credit score of 680 or higher is considered a “good” score, while 750 and higher is considered an “excellent” score.

Lenders typically offer lower interest rates to consumers with a better credit score. For example, someone with a score of 600 might pay an 8.9% interest rate on a 30-year fixed mortgage right now, while a consumer with a credit score of 700 would pay closer to a 6.5% interest rate.

Lenders also use a “grading” system (A, B, C or D) to determine the quality of a loan. In this system, an “A” paper represents the highest quality loan, and a “D” paper is the highest risk loan. For example, if your credit score is 680 or more, you fall in the “A” paper category. However, not all lenders rate credit the same way.

How does my credit score affect interest rates?
Obviously, lenders typically offer lower interest rates to consumers with a better credit score. However, because each lender rates credit differently, it can be difficult to predict what interest rate you’ll end up getting.

Typically, it comes down to your credit history and your debt ratio. If both of these look great on your credit report, the loan is most likely assigned an “A,” which qualifies you for the best interest rate.

However, if even one of the factors is not up to par, the quality of the loan is downgraded to “A-" or “B.” Consequently, your interest rate will increase because you pose a higher risk on the lender. Basically, the lender is compensated for the higher risk by charging you with a higher interest rate.

Other impacts on your interest rate:
Although lenders primarily look at your credit history and debt ratio to determine your interest rate, they also take other things into consideration. When lenders review a borrower’s credit score, it is also reviewed by an underwriter. The underwriter assesses your credit score using the following criteria:

Lifestyle History

• How long you've lived at your residence
• Whether you own or rent (Owning property earns extra credit)
• How long you've been employed at your current job
• Education level (College education earns extra credit)
• How much money you’ve earned and how credit you have used

Payment history

• Public record and collection items
• Severity and frequency of delinquent payments
• Outstanding debt
• Credit history
• Number of balances recently reported
• Average balance across all trade lines
• Relationship between total balances and total credit limits on revolving trade lines

Pursuit of new credit

• Number of credit inquiries and new account openings in the last year
• Amount of time since most recent inquiry
• Types of credit in use
• Number of trade lines reported for each type Bankcard
• Department store cards
• Personal finance company references
• Travel and entertainment cards
• Installment loans

Boost your score
There are many things you can do to improve your credit score and receive lower interest rates. Here are a few suggestions:
                                                                  

• Obtain a free copy of your credit report and check accuracy
• Make corrections to any mistakes on your credit report using the proper documentation
• Pay your bills on time each month
• Keep balances low on credit cards
• Don’t apply for more credit cards than you need
• If your credit card company increases your line of credit and you don’t need it, ask them to reduce it
• If you’re planning on applying for a home loan, don’t apply for a car loan, credit card or any other major loans until after you have purchased the home