Lenders like banks and credit card companies use credit scoring algorithms, which are mathematical models, to assess the creditworthiness of individuals and businesses. These algorithms take into account various factors to determine the likelihood that a borrower will repay their debts on time. The resulting credit score is a numerical representation of the borrower’s credit risk.
Several key elements play a role in these credit scoring algorithms:
1. Credit History: This is one of the most crucial aspects when determining a person’s credit score. It encompasses information about past and present credit accounts, payment history and the age of those accounts. Instances such as late payments, defaults or bankruptcies can have adverse effects on one’s overall score.
2. Credit Utilization: This factor examines how much of the available credit a borrower is using. A high utilization rate (meaning utilizing a large portion of available credit) can negatively impact their credit score.
3. Credit Mix: Lenders also consider the variety of different types of credit accounts that borrowers possess, including but not limited to: credit cards, mortgages, auto loans and personal loans. Having a diverse mix of these accounts tends to have a positive influence on one’s overall credit score.
4. New Credit Inquiries: Having a lot of credit applications and hard inquiries can have a negative impact on your credit score. Lenders may perceive it as a sign of financial instability or excessive need for credit.
5. Length of Credit History: The length of your credit history plays a significant role in determining your credit score. Generally, the longer you have responsibly managed credit, the better it is for your overall score.
Credit scoring models may differ, but two widely used ones in the United States are the FICO score and the VantageScore. Here’s a brief overview of each:
1. FICO Score: The Fair Isaac Corporation developed the FICO score, which is considered to be the industry standard for credit scoring. It typically ranges from 300 to 850, with higher scores indicating better creditworthiness. Factors like payment history and credit utilization play a crucial role in calculating FICO scores.
2. VantageScore: Developed by Equifax, Experian and TransUnion (the three major credit bureaus), VantageScore is another popular credit scoring model. Like the FICO score, it ranges from 300 to 850 and considers similar factors. However, its specific algorithms may vary slightly depending on lenders preferences.
Different countries and regions have their own credit scoring models and lenders might also use their own unique models. It’s worth noting that these models are always changing to become more accurate and relevant. It’s important to understand your credit score and the factors that affect it so you can manage your financial situation well and get access to credit on favorable terms. You have the option to get a free credit report every year from the major credit bureaus, which allows you to keep an eye on your credit history and make informed decisions about your finances.