Credit scoring is a method used by credit bureaus to determine how much credit they should grant. Your personal credit score is curated using information provided by credit bureaus. The FICO scoring model is currently the most popular model in the world. It includes a three digit number which ranges from 300 to 850. The higher your credit score, the greater your creditworthiness mark. A high level of creditworthiness qualifies any individual for credit at favourable interest rates. An alternative to credit scoring would be to leave the entire decision process to a loan officer. Obviously, this is unfavorable for a number of reasons, one being that the score is more likely to be subject to bias, discrimination and credit risk inaccuracy. Credit scoring allows lenders to make more accurate and objective decisions which help to properly adjudge their risks. Despite the accuracy of the credit scoring model, credit scores are not always universal. Infact, many factors, depending on the model or industry, can affect the exact same score. Some models, outside of FICO, may use a different range for their scoring process and different industries consider different factors when it comes to determining your credit score. The risk of falling behind on a mortgage or car payment is different from that of falling behind on a loan payment, because of this, different scores may consider the specific industry or credit type you wish to obtain. In addition, there are generally different formulas which could be used to determine your credit score. However, regardless of the formula in use, there are five factors that are likely to affect your credit score. They are: payment history, credit utilisation, length of credit history, mix of credit, and new credit. These components are used by the FICO model, the most common model for credit scoring.
Here is what each factor has to say about you:
Payment History: This is the most important factor in determining your credit score since it makes up for about 35% of the total score. It is a detailed track record which reveals the timely manner in which you pay back your bills. This factor includes all your payments on retail accounts, credit cards, installment loans (such as student or automobile loans), company accounts and mortgages. Since credit bureaus often have access to this information, a history of timely payments will increase your score while late or missed payments will reduce it.
Credit Utilization: This is the next important factor that accounts for 30% of your total score. It considers your total debts versus the total amount of credit you have at your disposal. It reveals how deep you are in debt and helps to determine if you can handle what you owe. A good rule of thumb with this factor is never exceed 30% of the credit limit on a credit card. For instance, if you use ₦10,000 on a credit card with a ₦100,000 limit, your credit utilisation would be 10%. Inversely, if you use ₦90,000, your credit utilisation would be 90%. A low credit utilisation rate shows that you have relatively little debt, giving the impression that you have a stable job and do not heavily depend on credit.
Length of Credit History: This factor measures how long you have had and used credit, it takes up 15% of your total score. The longer your credit history, the better your total credit score to lenders, especially if you have a track record of timely payments.
New Credit (Inquiries): This factor takes up 10% of your total credit score. It suggests that you might be about to take on debt. By opening several credit accounts within a short time, you fall into the category of high risk, potential defaulters, especially for people who don’t have a long standing credit history. Every time you apply for a new line of credit, the application counts as an inquiry or a "hard" hit. In contrast, “soft” hits include your personal request for your credit report and does not affect your score.
Credit Mix: This includes the “mix” of credit that is readily available to you and this contributes 10% to your overall credit score. This includes retail accounts, credit cards, mortgage loans and finance company accounts. With more lines of credit, your credit score will improve. You don’t need to have each type of account.
On A Final Note
Knowing how credit scoring works could help improve your overall credit score and financial health. Once you understand how it works, it becomes easier to take purposeful actions towards building your credit score, which might include coming up with a repayment plan. Some measures which can be helpful for your credit score include keeping your debt as low as possible, asking for limit increases on your credit cards, and automating your payments to avoid defaulting.