The importance of your credit score can never be stressed enough. Banks and other financial institutions use this number to estimate how much of a credit risk you present. Thus, it affects a lot of your transactions with them, such as when you apply for a credit card or a loan. A low credit score can make your dream of having your own home, starting a small business or even getting a decent car a more difficult goal to achieve.
Fortunately, credit scores aren’t fixed and permanent. They can go up or down depending on your money management practices. That means there is always a chance for you to improve your credit score.
How credit scores work
Credit scores are calculated through statistical analysis methods. Banks and lending companies gather information about you that is relevant to your financial stability and how you manage your money. Some of the more typical data they may use in their analysis are:
- how you’re employed
- how long you’ve kept your job
- how long you’ve lived in your current address
- the number and value of your assets
- your payment history
- your outstanding debts
Each of these factors will be assigned their own weight, and combined to come up with a final score. This number is then compared to the scores of other individuals of similar background. An average or ‘passing’ score is usually set by the financial institution, and your score will also be compared to this. How much of a credit risk you may present is expected to correlate to how your credit score measures up to this average.
Take note that the kind of loan or credit application you are requesting may require additional factors to be taken into account in calculating your credit score. In a home loan for example, the kind of property you plan to buy with the loan is considered. Meanwhile banks will want to know how many credit cards you already own and how well you’re maintaining them when you apply for another credit card account.
Different calculation methods
It is entirely possible to have a good credit score with one lender, and yet a ‘failing’ score with another. This is because different institutions may use different ways of computing your score.
These scoring methods are often proprietary information, and are protected by privacy laws. While it is true that some form of statistical analysis is always used, you have to understand that there are various mathematical methods that can be applied. (For the benefit of our more mathematically-minded readers, some examples of these would be the Chi-squared Automatic Interaction Detector (CHAID) technique and the random forests method.)
You also have to take into account that credit scores are actually just a number, without a fixed meaning. It is still the lender who decides what is or is not an acceptable credit score for an applicant. For example, a bank may decide to set a higher passing score for home loans if it’s low on funds or is no longer focusing on this type of product.
Improve your credit score
You have to know your current status in order to effectively improve your credit score. Banks rely on credit reference agencies to supply them with the necessary information for computing your score. However, it is possible for credit reports to contain inaccuracies. Any errors may negatively impact your rating. You can always request a copy of your credit report so that you can spot any mistakes and take action to have them corrected. This will also help you monitor your financial status and performance.
Scoring systems usually compare how much debt you’ve incurred to how much credit you’re maintaining. It may be a good idea, then, to keep your ‘good’ but old credit accounts even if they’re not active. Among other things, it would show a longer history of good credit performance. In terms of avoiding credit card debt, try to keep your balance within 25% of your limit whenever you can.
Finally, nothing signals good money management as simply and clearly as paying your bills on time! Payment history is often the biggest variable in credit score calculations. If you can be consistent in this area, you may encounter fewer obstacles in your future credit applications.
Image by Alex E. Proimos
