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How Credit Ratings Work

How Credit Ratings Work Photo

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Credit ratings are 3-digit numbers you can see in your credit report. It represents your credit status and can be used to check your financial capability. It is mainly based on your history of borrowing and repayment.

What are credit ratings? How does it affect one’s life and future plans? This article will help you understand the basics underlying this system.

Its purpose

As an addition to background checks, the credit rating of an individual helps in determining if he/she is financially stable and responsible.

Before approving an application for loan, a thorough check is done by agencies. Lending companies check an individual’s background and credit rating to assess if he/she can shoulder the debt. Companies wouldn’t risk their money lending to someone who has a poor credit history.

It’s also used by some landowners to check if an applying tenant can pay the monthly rent. Some employers also check an applicant’s credit rating to determine if he/she can handle the job properly, especially when it’s related to money handling.

The beginning

It starts the moment you borrow money – using a credit card or applying for a loan or mortgage. Everything that follows will be recorded in your credit history. That’s why people should be more careful in using their cards early in life as it can affect their future dealings.

Grading system

Major crediting agencies in the US use the system created by Fair Isaac Corporation or FICO. A higher score indicates a good rating and having higher chances of getting better interest rates in deals.

The FICO score is composed of the following components:

  • Payment history (35%) – how timely the bills are paid. Late payments cause the score to drop.
  • Credit utilization (30%) – the ratio of debt to the credit limit.
  • Length of credit history (15%) – a credit account that has been open for a longer period of time can have a positive impact on the FICO score.
  • Types of credit (10%) – managing different types of credit also have a positive impact on the score.
  • Recent searches for credit (10%) – frequent inquiries for credit report can do harm to a score especially if the reason for the inquiries is not reasonable enough.

Although there are some differences in the formula used by major crediting companies, more or less, it revolves around these aspects.

The effects

Depending on your credit rating, lenders could reject or accept your application for a loan. If they see that you’re responsible in paying, a higher chance of getting a better deal will be available.

Individuals who have good scores also have greater bargaining power. Since they’re more credible, they can strike deals that will is more favorable in their situation. Better interest rates and more flexible payment periods are some of the perks of having a good rating.

Credit problems

Any discrepancy should be immediately reported to be corrected. Little errors in the report can affect your rating and possibly your future plans. Errors would be harder to track if they’ve been on your report for years, so speedy action is needed for corrections.

There are reports regularly generated by your agency to provide you sufficient information about your current credit status. Keep them together with other proofs of transaction for future references.

Improving your rating

Since your credit rating has a big impact on future loans, use of credit cards should be planned carefully. Your rating should improve as you become financially stable.

Limit the amount of credit cards you use. It’s harder to maintain multiple credit accounts, minding all the payments you need to do at the end of every period. Also, it could be more tempting to spend when you have lots of credit room.

Pay your bills on time and avoid missing payment dues. Missed payments have a bad effect on your credit rating and can also hamper your purchasing power. As much as possible, spend only an amount of credit which you can pay in one go.