When a consumer decides to apply for any type of loan or credit card there is the compulsory task of completing the required application documents. However, the process goes far beyond the preliminary form-filling procedure. Lending institutions are going to delve deeper into the consumer’s background to ascertain their ability to make the required payments on any credit purchases, or determine their capacity to pay back what funds the lender is deciding to loan them. This is accomplished by investigating the borrower’s credit ‘worthiness’ prior to any loan approval or extension of credit through a careful examination of the borrower’s credit standing via an official credit report.
What is a Credit Report? The Basics
The information contained in a credit report is a detailed summary or breakdown of a borrower’s entire credit history. This report is made available to any lending institution or potential creditor upon request, and is statistically compiled by any one of three individual credit bureaus – Equifax, Experian, and TransUnion. Approval from any lender for any type of funding, whether it is a home mortgage, credit card, car loan, gas card, or even student loan is entirely dependent on the lender’s evaluation of the data contained within the credit report, and the bottom-line factor determining a favorable credit approval is the credit score.
The fundamental element of a credit score is a 3-digit number compiled from the borrower’s complete credit history, which is calculated to establish a numerical value indicating not only the risk factors involved, but the ability of the borrower to pay the debt, and in what time-frame. These computations balance the previous financial performance of the borrower against the estimated future debt repayment behavior. Therefore, the lender is able to actually measure the ‘potential’ repayment activity of the borrower to make the payments in a timely manner, and eventually repay the entire debt as agreed to in the terms of the loan.
How is the Credit Score calculated? The Math
Typically, the credit reporting bureaus use a breakdown of percentages to determine the final credit score, which are grouped into five areas of concern and importance when determining the overall ‘picture’ of a borrower’s worthiness as a credit risk. These percentages are the payment history, the amounts owed, the length of credit history, new credit issued and inquiries, and types of credit used by the borrower.
The Payment History (35%) – This is the most important criteria, which describes how and when the borrower made payments to his or her various creditors – credit cards, mortgages, car loans, retail accounts, health insurance premiums, and even utility bills. Factors such as delinquencies or late payments reflect in the credit score unfavorably, while loan pay-offs, and a timely payment history will naturally keep a credit rating in good standing or improve it over time.
The Amounts Owed (30%) – This percentage is determined by the total debt owed by the borrower, as well as the comparisons between the proportions of what was borrowed against the original loan amount. This is what is referred to as the all important ‘credit-to-debt’ ratio. The more the borrower owes, the more of a risk the borrower will appear to the creditor.
The Length of Credit History (15%) – This percentage simply translates into ‘the longer the better’ in any lender’s evaluations. All creditors prefer to see a borrowers credit activity for a long period time, that it was used intelligently, and that it was used frequently. The longer a ‘good’ credit history is, the better the credit score.
New Credit Issued and Inquiries (10%) – This percentage is a general picture of all recent credit activity, whether it reveals any new loans or accounts issued, or any recent credit inquiries done by prospective lenders or even employers. The more inquiries there are, the greater the likelihood of a credit report being negatively impacted.
Types of Credit Used (10%) – All lenders prefer to see a wide variety of activity over a good cross section of loan types – a few credit cards, a car loan, a mortgage, service and utility bills – and all with timely payment histories.
What is a Good Credit Score? The Bottom Line
Credit scores are tabulated into a range of 300 to 850. Of course the higher the score is, the more favorable the borrower will stand in getting approval, simply because there is less risk involved to the lender, and therefore the lower the interest rates. A score above 700 is viewed as excellent, while a 680 is considered very good. Scores in the middle range categories like 560 to 600 will naturally be charged much higher interest rates, and certainly face more careful scrutiny from the lender. It is important for the borrower to understand that every lender or employer is different, as are the factors used by each of the credit bureaus in weighing the final outcome of a borrower’s credit status. Additional considerations such as employment history and income also play a major role in a favorable loan or credit decision.