Credit scores are decision-making mechanisms used by lenders to assist them in assessing how likely the borrowers are to repay the loan on time. Often referred to as risk scores, they assist lenders to determine the risk of not being able to repay the loan as decided by the borrowers. Lenders, including banks that provide mortgage loans and credit card firms, use credit scores to make decisions on whether or not to offer the loan and what the terms of the offer would be.
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What is a FICO score?
FICO® scores, developed by the Fair Isaac Corporation, are one of the most well-known forms of credit score. It is a three-digit number that is used to assess how likely the credit is to be repaid by an individual. It is an assessment of a specific credit agency regarding the capacity and readiness of an entity (government, business, or individual) to satisfy its monetary fulfillment and within the set up due dates. A FICO score likewise means the probability that a borrower will default. It is also representative of the credit risk carried by a debt instrument – whether a bond or a loan. It is not, however, an affirmation or promise by a debt instrument or individual debtor of some kind of financial performance. The opinions of a credit rating agency do not replace those of a financial advisor or portfolio manager.
Why is FICO score important?
FICO score helps millions of people like us to access the credit they need to do things like getting an education, buy a first home, or cover medical expenses. Some of the companies check the FICO score while setting up the terms of service. The truth of the matter is, a decent FICO score can spare you thousands of dollars in interest and fees as lenders are more likely to extend lower rates if you present less of a risk-free for them. The more available credit is, the more moneylenders can advance and the more proficient they can be in their cycles to drive costs down and give reserve funds to the borrowers.
Factors considered while calculating FICO scores:
- Payment history: According to FICO, past long-term behavior is used to forecast future long-term behavior. It also considered the frequency, recency, and severity of reported missed payments. One of the best ways to improve the score is to make consistent, timely payments. It accounts for 35% of your FICO score.
- Credit utilization: FICO says people with the best scores tend to have an average credit utilization ratio up to 6%. They also take into account how are you able to handle your debt responsibly. It makes up 30% of your total score.
- Length of credit history: It’s impossible to have a perfect score if you’re new to credit, but it doesn’t take long to achieve one. A longer history provides more information and therefore a better picture of long-term financial behavior. Those who don’t have a long history can still have an excellent FICO score provided timely, consistent payments. It makes up for 15% of your score.
- New credit: While new credit accounts for 10% of your FICO score. But this doesn’t mean that opening multiple credit lines at the same time will improve your score. In fact, such behavior could suggest you are in financial trouble by needing significant access to funds. New accounts will lower your average account age, which will have a larger effect on your FICO scores if you don’t have long credit information.
- Credit mix: It makes up the last 10% of your FICO score. While this is somewhat considered a vague category, experts say that repaying a variety of debt products indicates the borrower can handle different categories of credit. According to FICO, historical data indicates that borrowers with a good mix of revolving credit and loans generally represent fewer risks for lenders.
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FICO score ranges:
It is a number that represents the risk a lender takes when a person borrows money. Your credit score calculation represents your credit risk at a moment in time, based on information found on the credit report. FICO score ranges from 350-850. The higher the credit score, the lower is the risk. FICO scores are used in 90% of all lending decisions, so it is a pretty accurate reflection of your creditworthiness as a lender might see. Ranges are as follows:
- Exceptional credit score: 800-850
- Very good credit scores: 740-799
- Good credit score: 670-639
- Fair credit score: 580-669
- Poor credit score: under 580
- No credit: under 350
Author – Priyanshu Ahuja
About the author – I’m a first-year student from City Premier College, Nagpur, pursuing BBA. My interest includes financial markets and investment domain.