- Personal Finance»
- Understanding Finance
Credit Reports and Credit Scores: How do they Impact your Financial Future?
The Link between Credit Scores and Loan Approvals
Need a mortgage or car loan?
The first criteria for approving your loan application will be your credit score. Lenders will first look out for their own interests before approving credit. The logic is straightforward: If your credit rating is good, there are higher chances of getting approved for a loan.
If your credit rating happens to be low, then there is a strong likelihood that the lender might reject your loan application. Your credit score also decides if the lender will offer you the loan at favorable rates.
A low credit score will tend to attract higher rates and more stringent terms as the lender is nervous about safeguarding his money.
Your credit rating is an integral part of your financial health and plays a crucial role when it comes to borrowing money (credit). Since a lot of important things including homes, cars and college educations are bought with loans, your credit score becomes an important barometer of your credit-worthiness.
What is the Meaning of 'Credit Rating' or 'Credit Score'?
What exactly is Credit Rating?
Credit score or rating is a number that describes your ‘borrowing behavior’. Borrowing behavior refers to your ability to repay a loan, based on past data. If you have been able to repay all your loans on time and in full, you are likely to enjoy a higher credit rating. On the other hand, if you have borrowed loans in the past and defaulted on repayment, this is more likely to hurt your credit score. Your score tells a prospective lender that you may not be a safe ‘bet’ as far as lending money is concerned.
All lending institutions including banks, credit unions and mortgage lenders etc prefer lending money to reliable borrowers. This way, they are confident of getting their money back along with the interest amount in the stipulated time period.
When you borrow a loan, you agree to return the loan (the principal plus the interest) in a certain time-period. An important point concerning joint loans: If you are married and both spouses wish to be co-signees on, say, a home loan, both credit scores will be scrutinized by the creditors before the loan is approved.
A credit score indicates the likelihood that you will be able to repay the loan as specified in your loan agreement. The higher your credit score, the higher is the likelihood of locking in favorable rates of interest on your loan.
Understanding the Difference between Credit Reports and Credit Scores
You might often find these two terms used interchangeably but although they are related, they actually mean different things. If you mistake one for the other, it could have a negative impact on your financial health. Credit reports and credit scores are two different concepts and are intended for different purposes.
Here’s a closer look at each one in detail.
A credit report contains a summary (along with details) of your credit history. The report will contain information about your dealings with lenders, banks, landlords, utility companies etc.
Here’s a list of information that you’d typically find recorded in a credit report:
- Your personal information including name, address, phone contact, email and social security number
- Information on the type of credit that you use
- Information about your ability to pay your bills on time
- Details about your credit card history plus descriptions of your loan transactions with banks and other lending institutions
- Information regarding any bankruptcy filings in court or tax evasion records
- Details of any new credit that you have opened (for example for a business)
Credit reports are prepared by different agencies and each consumer is allowed at least one free credit report during a 12 months’ duration. The newly amended FCRA (Fair Credit Reporting Act) stipulates that each consumer is lawfully allowed one free report every year. If you’d like to order extra reports, you can do so at a nominal charge.
As a matter of fact, it’s a good idea to check your credit report once a year to ensure that all the information recorded is correct. If two or more agencies generate credit reports from different agencies, there are likely to be discrepancies between the reports.
These anomalies arise because each agency collects its data from different sources. The different credit agencies collect their data from two main sources: Credit institutions (banks, lenders, credit unions, mortgage lenders etc) and court records (where they examine your data for bankruptcy, non-repayment of debts etc).
The terms and rates of interest offered by your creditor will depend on the agency that he uses to get your credit information.
Your credit score is calculated by using a complicated (and often patented) formula. The credit score consists of 3 digits and is calculated based on the information in your credit report.
Credit score is calculated by taking five main factors into consideration:
Payment history: All financial history including loans and repayment (35%). A history of prompt repayments helps while missed payments hurts your credit score.
Total amounts owed to creditors (30%): This is the total amount that you currently owe in debts. The less you owe, the better is your credit score.
Length of Credit currently being used (15%): This refers to your credit timeline. A history of responsible credit management and timely repayments will increase your score.
New credit (10%): This includes any new lines of credit that you may have applied for.
Type of Credit being used (10%): The nature of the credit could include credit cards, home loans, car loans or mortgages etc. The lender will assess your ‘mix of credits’. For example, using your credit card to purchase an air-balloon could hurt your score!
Basically, all your credit history is boiled down to three digits. The prospective lender or lending institution is able to tell, at a glance, whether he should consider approving your loan and the terms he should offer if he does. As a rule of thumb, any score below 620 falls under the low credit score category and any score above 650 is counted as high.
Financial Implications of a Low Credit Score
A low credit score can have a serious on your financial prospects. Oftentimes, people do not know what their credit score is until they want to make a big purchase like a home or car or even start a business. It’s only when they attempt to borrow a loan that they realize that their low credit score is getting in the way of getting approved.
Be careful before you stretch your credit card and spike your debt levels; this has a detrimental effect on your credit score and will lower your chances of getting approved for loans in future.
6 Ways a Low Credit Score Can Impact your Financial Future
- A low credit score will attract higher rates of interest on credit cards
Credit card companies are already notorious for levying exorbitantly high rates of interest. The rates that you pay on your credit card vary from 13% to 15%. If you have a low credit score, the lender will be inclined to offer higher interest rates in order to offset his risk (lenders perceive people with low credit scores as riskier than those with healthy credit scores).
- Higher security deposits for utility bills
Whenever you move into a new home, the utility company checks your credit history before approving your application. So a bad credit score could imply that you probably would have to pay a higher deposit amount even if you’ve been paying your utility bills on time.
- Higher chances of loan rejections
Low credit scores have a seriously negative impact on your chances of getting a home loan. Deciding to buy a home is one of the most significant decisions of your life. A bad credit score can jeopardize your chances of getting approved and what’s more, there are higher chances of getting multiple rejections.
- Unfavorable terms on insurance policies
If you want to buy an insurance policy (for your home, car, business etc), the provider is likely to check on your credit score. A low credit score indicates higher risk (unpaid premiums, late premium payments etc) and the provider will cover his risk by upping the premium rates.
- Higher chances of job rejections in senior management
Senior management jobs especially in the finance industry require employees to have a respectable credit score. A low credit score indicates that you may have a history of unpaid loans, bankruptcy or lawsuits and often leads to rejections.
- Difficulty in procuring credit for your business
Gaining access to credit or a loan is mandatory for starting your own business. A low credit score can make it difficult to find the funds that you need to get your business off the floor. Again, lenders will tend to view a low credit score as a higher risk and will be nervous of lending you money.
Even if you are able to get approval, it might be on unfavorable terms. Paying higher rates of interest will impact your financial status negatively as every dollar counts when you’re just starting out.
It’s crucial to manage your credit. Good credit management increases your chances to borrow loans and has a major impact on the quality of your life. As a matter of fact, you may end up spending more money in the form of higher interest rates and unfavorable terms of payment. It pays to clean up your credit report and repair your credit score.
Source: Astute Credit