The Impact Of Credit Scores
By Daniel Lewis from Finimpact
The concept of a credit score is one that seems to be laden with myths and misconceptions. In this article, we’re going to run through these myths and give you a thorough understanding as to what makes a good credit score, how to raise your credit score, and what to avoid when establishing a good credit rating. We will define what a good credit score actually is and how you can raise yours in the most direct manner possible.
What are Credit Scores Anyway? The credit scoring system underpins business and finance in the UK. It is an essential means of determining how reliable a person or business is. Without this system, it would be nearly impossible to determine who to lend capital to. Lenders need a way of rating applicants.
Credit scores are used to apply for loans of all kinds, as well as mortgages. Not only will the credit score determine whether or not you get a loan – it will determine the all-important rate of interest, and how much you pay for the loan in total. The better your credit rating, the lower the rates you will get. You may also benefit from an expedited loan process with a better credit score.
UK citizens need to get loans for a variety of reasons – home improvements, going to university, buying a car, starting a business, etc. And without a good credit score, they might not be able to access these fundamental functions. Some employers will even check your credit history to see if you are fit for the role, and insurance companies will nearly always check them when evaluating your application. The bottom line is that everybody needs a credit score, and it is better to have a good one.
Factors Affecting Credit Score
There are a number of factors affecting a given credit score. These include:
Your payment history (missed v on-time payments)
The total amount of outstanding debt
The number of credit accounts you own
The different types of credit you own
The total age of your accounts
These are the basic and most important criteria. But what you need to remember is that payment history is the most important. Lenders want to know if you make all of your payments on time. This shows that even if you have a large number of accounts and huge outstanding debt, you still have the capability to make your payments. And this is what financial institutions love – you are in debt, but still, make payments.
Understanding Credit Reports
If you are looking to raise your credit score, then you will definitely want to request a credit report from each of the 3 credit reporting agencies. You can do this for free and without having an effect on your credit rating score. But you are only entitled to one free report every year.
This is known as a ‘soft’ inquiry. For information on how to get your free report. The credit bureau will list the most obvious reasons that your credit report is not higher, which is very useful for those trying to understand their credit scores.
A ‘hard’ inquiry occurs when you request a credit report more frequently or when your lender pulls your credit report after you make an application for a loan. Unfortunately, you have to be careful here. It can have a negative impact on your credit score, though the effects are not huge. Employers and insurance companies may also pull hard inquiries.
If you apply for a mortgage loan or a credit card, the lender will check your credit score with a hard inquiry, though this can only be done with your permission. The reason a hard inquiry can affect your credit score is that they typically mean that you are looking at new kinds of credit. So if you have a lot of hard inquiries it means you are opening a lot of new accounts, which can impact your score.
Proven Techniques to Raise Your Credit Score
Raising your credit score is not rocket science. All you have to do, literally, is make payments on time and pay down your total outstanding debt. However, it does take time. A good strategy could be to take out a single loan and make payments on time each month.
After a year or so, your credit score should rise. But realistically, you will want to have at least 2 to 3 years of making every payment. This will look very, very good to the reporting agencies. There is not much more to it than this – for example, you must pay back your utility bills on time, as they can be factored in.
Remember, it is best to have one or two credit accounts at the most and to focus on paying these back. Having too many different types of credit does not look good from the lenders’ perspective. They are really looking for a focused person with one or two types of credit and a long history of making payments on time, every time.
Understanding Credit Utilization Ratio
The credit utilization ratio is one of the least understood (but very relevant) factors in the credit ratings. It is how much of your total allowed credit that you happen to be using. For instance, let’s say that you have a total credit limit of £20,000 across various accounts. If you use none of it, then that is a bad sign.
If you use £20,000, that is an even worse sign. It shows that you are overly dependent on your card, which comes with high rates. The golden figure is often cited at 30%, so if you use around £6,000 and pay it back each month, your credit score will rise rapidly.
Each credit account you have will have its own unique credit utilization ratio. The credit utilization rate is based solely on your revolving credit. Revolving credit is simply credit cards and lines of credit. This is why car and mortgage lenders pay less attention to the credit utilization ratio. They take your debt to income ratio into account, which calculates how much of your income is taken up with outstanding debt.
Debunking Myths About Credit Scores
There are many myths surrounding credit scores. Here are just some of them:
Not having a credit card will give you better credit – This is false. Effective use of credit cards will increase your credit score. It depends on whether you pay back the credit on time.
Income is related to credit score – This is false. The credit bureaus do not actually have access to your annual income and total annual income has zero impact on your score.
It’s ok to miss a payment here and there – This is false. Aim to never miss a single payment. It is the most important factor in terms of a credit score.
It’s impossible to get a loan or credit card without credit – This is false. There are many providers for loans and credit cards for people without credit. You can also use a co-signer or a secured loan if you don’t have credit.
It’s always good to close unused accounts – This is false. But it is also a little complicated. Closing credit accounts might help your credit score, but it also affects your credit utilization ratio, which could lower your score. Age is also a factor, so it might not be good to close an old account that increases the history of your credit.
6 Things That Lower Your Credit Score (Regardless of Scoring Methodology)
Getting a good credit score is actually a lot simpler than it sounds. Just take out one or two credit accounts. Use the accounts every month, but only to about 30% of maximum utilization. And make payments every time. After this, just download your credit report every year and keep an eye on errors. Your score will rise.
#1 – Paying Bills Late
Paying bills and total credit utilization make up 65% of the total credit score as per the FICO rankings. And with other rankings, the numbers are similar. Paying bills late is the cardinal sin in terms of getting a good credit rating. It tells lenders that you are unreliable. So the number one way to destroy a credit report is to fail to pay bills on time.
Set up a system whereby you pay off the total amount owed each month. Use an application to check how much you owe and set up an alert. This is an area where it really pays to get organized. A poor credit score will make all of your financial endeavors more difficult.
#2 – Applying For Too Much Credit At Once
Every time that you apply for new credit, the lender will most likely conduct a hard pull on your credit history. This hard pull can lower your credit score by 5 points. Needless to say, a lot of hard pulls can really lower your score. This hard pull will stay on your record for over 2 months and is a sign of uncertainty. Hard pulls can be conducted when you are consolidating debt, refinancing a loan, even when you are renting a car (in some instances).
Opening up too many credit accounts at the same time also comes with other disadvantages. It will decrease the average length of your credit history, which may have an adverse effect. You will also be unable to use all of the credit accounts. This means that there will be a question mark over your spending history and financial institutions will be unable to assess your true creditworthiness.
#3 – Using Your Credit Card Too Much
There are different opinions on credit utilization. However, as a general rule of thumb, you don’t want to use more than 30% of your max credit limit. Otherwise, it will seem that you are overly dependent on credit. A person who constantly maxes out their credit limit is a red flag, even if they do pay on time regularly. So you will need to strike a balance between using the card but not overusing it. Anywhere between 5% – 30% of the max credit limit could be an advantage.
#4 – Cancelling Your Credit Cards
Canceling a credit card is not the end of the world, but it can affect your credit score over time. It decreases your overall credit utilization. It might also mean that your credit utilization on remaining cards is higher, which sends an adverse signal to the agencies. On the other hand, there are certain instances when you most definitely should cancel your credit card, if you are constantly overspending or if the fees are too high.
#5 – Making Large Credit Card Purchases
This is related to the point surrounding using your credit card too much. If you make a very large purchase, it will extend your credit utilization ratio and mean that you have to make a large payment. Payments on purchases can accrue month on month, so make sure that you will have the funds to pay it off. In general, there are better financing options for large purchases with lower rates.
#6 – Not Checking Your Credit Report
Credit reporting agencies are actually notorious for making reporting errors. It’s always good to file a dispute if you notice anything out of the ordinary. Remember that all agencies give you one free credit report per year.