Credit Scores and What They Mean

One often wonders whether information pertaining to bankruptcies, liens, judgments, and collections is really relevant. Again, credit inquiries by lenders, that could be the result of a person shopping around for the best rate of interest on loans, do not seem pertinent to an individual who is not well versed with the computation of credit scores. The reader, whose curiosity regarding credit scores and the computation of the same must be sufficiently piqued, may read on for clarification regarding credit scores and what they mean.

What do Credit Scores Mean for the Lender ?
The aforementioned seemingly irrelevant pieces of information are compiled by credit bureaus for calculating credit scores. The method of computing scores using the degree of indebtedness of a person, the length of their personal credit history, the availability and repayment of credit and frequency of applications for availing new credit are carefully documented and used to calculate credit ratings. The statistical basis for calculating the scores was developed by Fair Isaac Corporation (FICO) in the year 1958. It has become the basis for FICO, Empirica and Beacon calculated by Experian, TransUnion and Equifax respectively. The next generation user-friendly credit scores, viz. FICO advanced risk score, Precision and Pinnacle are also computed by the same credit bureaus. Credit scores lie between 350 and 850, both inclusive. Lender's prefer loaning money to people with credit ratings above 620 since higher scores are indicative of creditworthy borrowers. Since range is defined as the difference between the maximum and the minimum value one may say that the range of credit scores is 500.

What do Credit Scores Mean for the Consumer ?
The rate of interest, that is charged on loans, is a direct function of the risk involved in the process of lending. Since lenders use credit scores to determine the credit worthiness of a borrower, a higher credit score will help the borrower procure loans at a favorable rate of interest. The loan may be availed for buying a car, for pursuing higher education or for the sake of buying a home. One may also be approved easily for credit cards with low APR (Annual Percentage Rate). In fact, employees in positions of trust, may be assessed on their ability to manage finances on the basis of their credit report. According to the Fair Credit Reporting Act (FCRA), one is entitled to receive a free credit report, annually.

Credit Score Ranges And What They Mean
It's evident that every person is straddled with three credit scores that may not necessarily be equal. The point of a credit score is to gauge the ability of the borrower to meet financial commitments like loans. Hence, a person with a poor credit score will find it difficult to procure loans at a reasonable rate of interest, since he/she is considered a risky investment. Borrowers are classified as prime, sub-prime or shafted on the basis of their credit scores.

A shafted borrower is one whose score lies in the lower end of the range, somewhere in between 560 and 620. Credit score, in the range of 680 and 850, assures one of being qualified to avail loans at the prime rate of interest. A sub-prime borrower, with a score that lies between 620-679, would have to present a really strong case especially in the aftermath of the sub-prime crisis.

Practical Ways of Improving Credit Scores
One can hope to improve one's credit score by punctually paying off the balance on the credit card, at the end of each billing cycle, without being tempted to discharge just the minimum obligation. Existing lines of credit should not be canceled since doing so will increase the debt utilization ratio. The ratio between the outstanding balance and the amount of available credit is known as the debt utilization ratio. Again, increased credit limit will result in lowering the debt utilization ratio. A low debt utilization ratio is good for the credit score while a high ratio impacts the score negatively. Keeping track of inaccuracies in the credit report, paying off debts using lines of credit that are not revolving and limiting credit inquiries can contribute towards a good credit rating, ensuring that the borrower can avail cheap credit without any further constraints.