How to Handle Bankruptcy

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What Is A Credit Score And What Does It Mean?

In basic terms, a credit score is a number which represents a person’s perceived ability to pay his/her debts on time. Financial institutions such as banks and credit unions that are in the business of lending money look closely at credit scores to see if a loan applicant is a potential risk. If lenders did not use credit scores, the chances of applicants defaulting on the loan would be much higher. In the United States, the Fair Isaac Corporation (FICO) is the best known method of calculating credit score. FICO scores range from 300-850. The higher your score, the more likely you are to be approved for a loan. People with higher FICO scores tend to get better interest rates on car loans or mortgages.

FICO state that their exact formulas for calculating credit scores are top secret but they have divulged certain information. For example, 35% of the score relates to timing of bill payment. FICO scores drop when an individual is late paying debts. 30% relates to the ratio of revolving debt (usually a credit card balance) when compared to the overall credit limit. Those who apply and are accepted for credit card limit increases will see their ratio lowered which improves their credit scores.

15% of your FICO score relates to the length of your credit history. Aging credit history can increase your credit score. 10% of the score relates to types of credit used such as consumer finance or a mortgage. Showing an ability to manage different debt types is looked upon positively. The final 10% takes into account recent credit searches. Consumers who seek new credit can find that their score drops.

What Does My Credit Score Mean?
FICO state that the median score is around 720 with 60% of the population having a score between 650 and 799. Below is a quick guide to the numbers.

  • 720+: This is an excellent credit score which will see you approved for loans at the best rates. You can demand the best offers and may even receive up to 80% of your home’s value in loans. You should also be able to get a credit card with an interest rate of 10% or less, far below the 18% average.
  • 675-719: While this is still reasonable territory and will see you approved for almost every loan type, you will probably not receive the best rates available. For example, you are likely to pay 0.5% more on a fixed-rate mortgage than someone with a score above 720. On a loan of $150,000, the difference between 6.5% and 7% is a whopping $18,000 over the 30 year period.
  • 620-674: This is considered to be a below average credit score which means you will be forced to pay a premium on your loan. In most cases, you will pay 2% more than someone with excellent credit. You may still be approved for loans but expect to be asked to provide more documentation than those with higher scores. In this situation, it is important to work hard to repay loans and get that credit score up.
  • 619 or less: You are considered to be a ‘sub-prime’ borrower and will have more loan applications rejected than those with better credit scores. However, more lenders than ever are offering sub-prime loans. The downside is that you will pay much higher rates than people with better credit, up to 3% in most cases and will be forced to pay an interest rate of over 10% for a line of credit.

Your credit score affects the rate you pay for car insurance too. Statistically, individuals with low credit scores make more accident claims. It is possible that poor credit can hurt job searches and rental agreements. Clearly, you must work hard to improve your credit score as the benefits of doing so are profound.