Credit scores (or ‘ratings’) are used by banks and lenders to decide whether or not to lend you money.
They’re a measure of how ‘creditworthy’ you are, which means how likely you are to pay back the money they’ve lent you. When banks lend you money, they take on a risk: there’s always a chance people might not pay the money back. Your creditworthiness helps them decide how much they’re willing to lend you, and what interest rate they’ll charge.
Creditworthiness can be difficult to predict, because it takes into account a lot of different factors, like how likely you are to pay back the loan and if you can afford it.
Credit scores are a useful way of taking all those factors into account, and summarising them in one simple number. Along with some other information, that number’s then used to assess how risky or safe it is to lend you money.
Is a credit score the only thing lenders consider?
A credit scores is a useful indicator of how likely you are to repay what you borrow. But it isn’t the only thing that lenders take into account.
When deciding whether to lend you money, they consider a few different things:
Creditworthiness - how likely are you to repay?
Affordability - can you afford the loan?
Sustainability - can you keep paying money back for the length of the loan?
Each lender will set their own rules to help them decide whether or not to lend someone money. And these rules depend on how much risk and what kind of risk they’re willing to take.
For example, some lenders might not lend to people who don’t have enough credit history (a record of borrowing and reliably repaying money), others might only give credit to people who have a current account at that bank and use it on a regular basis.
So, when they decide whether to lend you money, lenders consider a range of different criteria. Your credit score is usually one of the most important, but it isn’t the only thing.
What makes up your credit score?
There is more information than ever out there on credit scores. Yet, people are still not aware of the 5 vital components that make up your credit score. We are going to go through step by step on what each component means and how much it affects your overall score.
Now lets’ start from most important to least important.
NEW CREDIT - 10%
Every time you apply from credit it leaves a mark on your report. This is called a “hard search”. If you you make a lot of applications in a short space of time this can have an affect on your score. To avoid this, check your credibility through a quotations search, this will not affect your credit score, this is known asa “soft search”.
CREDIT MIX - 10%
10% of your credit score is based on the kind of credit you have. A mix of credit cards and loans is best. Having a mix of credit in your file – mortgages, student loans, auto loans, credit cards – shows that you can manage debt from multiple sources.
LENGTH OF CREDIT HISTORY - 15%
Credit lenders like to see that you are stable and reliable so that you can be trusted to repay debt. There are 3 ways lenders determine your stability:
1. The average age of your credit accounts
2. How long you have lived at your house
3. Whether you are registered to vote
CREDIT UTILISATION - 30%
Using 75% of your credit limit could result in a red flag on your credit report and have a negative impact on your score. Between 50 - 75% would result in an amber flag and 50% or less would be a green flag.
PAYMENT HISTORY - 35%
Missing payments will be marked on your credit report, this is likely to have a negative affect on your credit score. However, if you miss multiple payments and become default on that debt, that is likely yo have more of an impact; penalties will be more serious and scars will remain on you credit report for 6 years. County Court Judgements will also appear on your report for 6 years. If any of these apply to you, lenders will be less likely to give you credit.
How is a credit score calculated?
Credit scores are calculated using statistical techniques. The goal is to find patterns in your previous behaviour that show things like how often you’ve missed payments, the total debt you’ve taken out, or the ratio between your income and the amount of money you’ve borrowed.
These things are used to predict the risk that you won’t pay back the credit. Each thing is given a ‘weight,’ and the more likely they are to predict that you won’t repay, the less weight they’ll carry. These ‘weights’ are all gathered together to determine your credit score.
Usually, a higher credit score means you’re less risky to lend to.
Who calculates my credit score?
Credit scores are calculated by credit reference agencies. There are three in the UK: TransUnion (which was previously called CallCredit), Equifax and Experian. These companies gather and record information about your credit history, and use it to calculate your credit score.
Lenders will ask one or more of these agencies for information about you, to help decide whether they’re willing to lend you money.
How do lenders use credit scores to make decisions?
Different lenders offer different products, and want to lend to different kinds of customer. They use credit scores to work out what you’re like as a borrower, and decide whether or not they’re willing to lend you money.
Some lenders want to lend to high-risk customers (often known as sub-prime lending). Because they’re taking on more risk, they can charge more interest or offer less favourable terms. Those lenders might choose lend to customers who have very low credit scores. Other lenders are more conservative and less willing to take on risk, so they might only want to lend to customers with higher credit scores.
Your credit score helps a lender decide whether they’re willing to lend to you, and determine other things like:
How much they’re willing to lend you: Lenders use credit scores to help decide the size of the loan they’re willing to give you. It’s common that lenders will offer smaller loans to higher risk customers and vice versa.
The price of the loan: Lenders often use credit scores to develop risk-based-pricing (RBP), which means offering lower prices to low risk customers and vice versa
The collateral you need to put up: When you take out a secured loan, you pledge an asset (like a car or a house) as collateral for the loan. Lenders often use credit scores to determine what kind of collateral they’ll ask you to put down, and what loan-to-value ratio they’ll require
How can I find out my credit score?
The three agencies that calculate credit scores are Experian, TransUnion and Equifax. You have a legal right to check your file at any of these providers – although you might have to pay a small fee!
There are also companies that can tell you your credit score for free, every month. You can use ClearScore to check your Equifax score, but it’s worth getting your Experian and TransUnion reports too.
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