Understanding Credit Scores | Time-Tested Ways To Increase Your Score
In order for you to get a full understanding of credit scores, you will need to know how your credit score is scored. Read more about these time-tested ways to increase your credit score so that you can get a grasp of understanding credit scores.
Full Understanding of Credit Scores
To first understand your credit score, you need to know the background behind it. The credit score system was first developed by the Fair Issac company and that is why it is company known as the FICO score. Now it is scored by the top three major credit reporting companies: TransUnion, Equifax, and Experian. These three credit companies are for-profit companies which collect your information to determine your credit score.
You credit score is a numerical digit ranging from 300 to 850, where 300 is the lowest and 850 is the highest credit score you can get. Think of it as a game where the higher the number the better. It is easy to drop your credit score, but very hard and takes a lot of time to raise your score. The higher credit score you get, the harder it is to get a even higher score. For example, it is relatively easy to get from a credit score of 500 to 600. But it is really difficult to get from 750 to 850. In other words, it gets progressively more difficult to attain a higher credit score the higher you climb the ladder.
Having a high credit score tells lenders, banks, credit institutions, and other financial institutions that you are a low-risk borrower and that you will be more likely to pay them back. Take for example, you have two friends, Jane and Bob who want to borrow $100 from you. Jane has a hypothetical high credit score and has always been known to pay you back on time when she says she will and in full. Bob, on the other hand, has a hypothetical low credit score and is known to forget about paying you back and usually makes a ton of excuses about the money he owes you. Who are you more likely to loan money to? Of course the answer is Jane.
The same works for banks and other financial institutions who give out personal loans, mortgages, credit cards, or car loans. They want to be sure that they will be paid for the money that they loan out. That’s where interest rates come in handy.
Let’s go back to our original example. Let’s say you will charge interest to both your friends to loan them money. They will have to pay back the $100 within a month and after a month, Jane will owe you $105 and Bob will owe you $150. The interest charged for both your friends is $5 and $50 respectively. Now let’s say you have 100 friends like Jane and 100 friends like Bob. Out of those 100 Janes, 99% of them will pay you back because they have a hypothetical high credit score and a reputation of paying you back. Out of the 100 friends like Bob, only 75% of them will pay you back. These Bobs have a low credit score and have a lower chance of paying you back. The interest charged will help minimize the risk. Let’s do the math:
You will lend 100 Janes, $100. You’ll get 99% back and get $9,900 back plus the extra $5 from those 99 Janes. This will make you an extra $395 in interest.
Now, Bobs on the other hand, you’ll only get 75% back. That means you’ll only get $7,500 paid back. But because of the high interest charge of $50 you get back, those 75 Bobs will pay an extra $50 netting you $1,250 after your $10,000 has been paid off.
This is essentially the same way banks and financial institutions work when they loan you money and charge you interest rates based on your credit score. This should give you a better understanding credit scores and how they work.