Many people(including Chinmay) have been asking me to write about personal finance. And finally the time as arrived for me to create a new category “FINANCE” on my blog and publish the first post 🙂
One of the most fundamental thing in personal finance is Credit & Credit Score let me try to explain it in as simple words as possible.
What is credit?
Before understanding Credit Scores, we need to know what Credit means. Simply, Credit is borrowing.
Here is the scenario. Let’s say you need a new computer for work but you don’t have $1200 for that flashy new Mac Book. Suppose a Third Party says they will lend you the money and you can pay them back when your paycheck comes after a month, with some interest.
In this situation,
- Third Party – Bank ( Standard Chartered, HDFC, Axis Bank, etc.)
- The Payment Method – Credit Card
- The Seller – Apple
- The Buyer – You
Apple inc. will accept your credit card of Standard Chartered Bank as payment, even though you have never paid a cent. This is because your bank (Standard Chartered) pays Apple inc. for you. Now Standard Chartered Bank will collect the money from you in instalments(EMI), along with some percentage(sometimes 0%) of interest for their services. You get your laptop before the end of the month, possibly earning some money using that computer.
If you’ve lent money to anyone, you will know that the biggest risk is getting the money back. Standard Chartered Bank has the same problem. Suppose Standard Chartered Bank doesn’t trust that you can pay them back. To convince them to loan you the money you need to prove that you can pay them back. The best way to do that is to point out how you’ve always paid back the loans you’ve taken. But where is the history of all these previous transaction?
What is Credit Score?
According to the Credit Karma Website,
“Your credit score is a three-digit number that relates to how likely you are to repay debt. Banks and lenders use it to decide whether they’ll approve you for a credit card or loan.”
So the Credit Score is a 3 digit number that tells the bank how likely you are to pay them back. This plays a major role in deciding whether you’re getting a loan or not. It also decides how much your credit limit will be, i.e., how much of money you can spend. If your credit limit is $5000, you can spend $5000 in a month. If you try to spend more, either your card will be declined because you’ve “maxed out” your credit or you will be fined for overuse of your credit card. The bank policy decides that option.
Credit.com defines the range in this way –
Most credit scores – including the FICO score and VantageScore 3.0 – operate within the range of 300 to 850, and a good credit score is typically one that is 700 or above. Within that range, there are different categories, from bad to excellent.
Excellent Credit: 750+
Good Credit: 700-749
Fair Credit: 650-699
Poor Credit: 600-649
Bad Credit: below 600
How is Credit Score calculated?
Now the big question is “How is the Credit Score calculated?” The better question is who calculates the score? Because someone, somewhere is deciding how much risk you pose to a bank. This is where things get tricky.
There are 3 main credit bureaus –
Their main job is to create reports on your payment status. They will look at multiple factors, including how often you make your payments, whether you make your payments on time, how many accounts you have, how many loans you were able to close successfully, how many issues were faced by the bank, etc. This will provide the basic data to make a profile on you.
Credit scoring is done by using standards such as VantageScore and FICO ( Fair Isaac Corporation). These are models used to measure the credit-risk of a person. Fair Isaac Corporation was the first company to offer such a service to banks. Overtime, new and improved models were also created. However, there is no universal standard. This causes a big problem as you might have different scores under different models. Don’t be alarmed. It is not strange to have different scores under different bureaus and standards. It’s due to the fact that not all transactions made by you are reported to all the bureaus. Some are missed causing a discrepancy among the different measuring standards. But that’s fine and nothing to worry about.
At some point Equifax, Experian and Transunion created VantageScore to standardise the scoring method. This would make scores consistent across different bureaus. Vantage version 3.0 is touted as being the most accurate model for scoring. It takes into account even your monthly rent and bill payment history. This could be beneficial to you if you pay your bills on time. Paying bills on time is responsible and trustworthy behaviour, which means that you do not disregard your responsibilities, indicating a stable and low-risk personality. Lower risk in turn will give you a higher score, increasing your chances of a higher credit limit and credit card perks.
VantageScore uses 3 scoring models and FICO uses a lot more. But, essentially, yhey look into the following details
- Your payment history
- How long you’ve been availing and using credit from institutions
- What kinds of credits you have (car loan, student loan, house loan, credit card, etc.)
- Your credit limit and how many times you’ve reached that limit
- How much debt you’re currently under
- Other factors seen in your credit reports
The key here is the credit reports. Keep an eye on them. If there are problems seen there, your score will suffer, potentially causing your loan requests to be denied or credit limit to be reduced.
For the privacy wary, no bureau will ever take into consideration or report any personal information such as race, gender, religion, marital status or nationality. The only thing that they will check is your history of paying back loans, and measure your risk accordingly.
Why Should I care about Credit Score?
This is a reasonable question, I guess. Why should we care about some score made by some credit bureau? If you’ve not understood the reason to care so far, we wish to stress again how important this score is.
Your Credit Score is your report card. This shows the world how well you can manage money and responsibly use it. Good, consistent behaviour is valued above all other traits. If you’re thinking about a home loan, or plan on buying a car with a loan or just using your credit card to make purchases online, you will need to have a good Credit Score.
More than that in todays world, you don’t know when and why you may need to borrow money(it could be even for medical emergency). Have a good credit score will come in handy in such situations.
Where can I check my Credit Score for FREE?
You can check your credit score for free from serval service providers like:
How can I improve Credit Score?
Experian provides a few suggestions on improving your credit score. The most important thing to understand is the fact that your Credit Score will look into the most recent payment history. This usually means 24 months. If you can make consistent payment for 2 years, your score should improve significantly.
- Start as early as possible. Age of credit history matter and today is best day to start 🙂
- Make sure to pay your bills on time. This has a major impact on your score.
- Use your credit sparingly. Make sure that your credit limit is not maxed out. Ideally, use up only 30% of available credit. This shows the bank that you can manage credit well, thereby increasing your credit limit.
- Don’t open unnecessary credit card accounts. Having a healthy count of credit accounts has a positive impact on your overall credit score.
- Make sure to pay off your debts. Don’t get new credit cards to pay off old credit card bills, for instance.
- Check your credit reports regularly for any mistakes or discrepancies. Clarify and correct the same at the earliest.
- Please note that bad payments and defaults remain on your report for 7 years.
It would be fair to say that we have really hammered down the point of how important it is to keep an eye on your Credit Score and how important it is for you.
Our advice to you is simple.
- Plan your budget carefully
- Keep on eye on unseen expenses
- Manage credit smartly
- Do not try to hide or misguide banks about your debt
- Be honest. Most banks will adjust credit to ensure debt reduction
- Make sure that you have an emergency fund/credit buffer for disaster management
- Make good, consistent payments as expected.
Stick to these basics and you will not be disappointed!
It takes only a little effort to have a good credit score and it will be a blessing in the time you need to borrow money. You have everything to gain and nothing to lose!