Understanding Credit Scores made easy

Why Do We Have Credit Scores?

Before moving onto understanding a credit score Understand Your Credit Scoreor a credit report, it is important to understand why we have these in the first place. Credit, or loans in general, are approved based on an individual / entity’s ability to repay that loan along with interest, if we’re talking about traditional banking / lending. So given that it is based on a person’s ability they have to see what they’ve done in the past. Obviously it is impossible to predict the future with a 100% certainty – so past records provide necessary evidence / information that helps in assessing / predicting the future.

What Is A Credit Report

A credit report usually provides a credit score that is based on the individual / entity’s credit history. I.e. reporting information on (a) whether the loan that was taken was paid back in full (or in part) and (b) when it was paid back (on time, late, early, etc). Typically, negative information in a credit report remains in there for about 7 years, with some information remaining for longer. Active, positive information can remain in a report forever.

Factors Contributing To Your Credit Score

Factors that tend to contribute towards a negative credit score or credit report include late payments, write offs (charge offs) – these are cases of creditors ‘writing off’ their debts because they think it is very unlikely for them to recover the amount(s). Other factors include repossessions of borrowed purchases / assets, as well as foreclosures. Arguably the most significantly adverse impact is that of a bankruptcy – in some cases, these can continue to be reported for 10 years. The same applies to tax liens which are legal impositions on properties in order to secure the payments of taxes.

The terminology used in a credit report is typically standardized throughout. This ensures clarity to the reader when viewing a given credit report or credit score. Moreover it ensures consistency and comparability of a given individual’s credit history, meaning the score can be interpreted in a true and fair manner.

If for instance a borrower has taken a loan against a collateral, and the borrower fails to pay the loan and/or the interest associated with it, then the borrower obviously has the right to claim the collateral’s ownership and this will also be reported in the credit report whilst adversely affecting the credit score.

Credit agencies use risk scoring models that quantify qualitative information about a given individual / entity’s credit history and then convert that to one number which can then be seen as a simplified summary of the entire credit history. Post recession, the number of unsecured credit /loans – these are loans offered without any collateral and typically based solely on the borrower’s word and a signed contract – being offered have fallen considerably.

4 comments

  1. I usually find all this credit score and loan based stuff incredibly confusing, but this article actually simplified it a lot. At the moment, my credit score is pretty much perfect as I’ve always paid back loans on time, and I rarely take out loans. I’ve bookmarked this post and will be referring to it in the future.

    • Hi Fred, congrats on having a good credit score! Good spending and repayment habits are key to maintaining that great score. Thanks for visiting and if you found this article truly helpful, I hope you will share it with your friends!

  2. Thank you for this detailed explanation of credit scores. I am admittedly new to applying for credit, as I do not use credit cards and I am taking out my first ever loan within the next few weeks, to pay for my business venture. I think that whilst it is a good idea to have a credit score assigned to each person, as it allows loan companies to stay clear of people who do not pay back their loans, it does mean that people who desperately need funds may not be able to get what they need, due to past failure to pay back their loans. Since I have never taken out a loan in the past nor used credit cards, I should have a perfect credit score, so hopefully I should be able to get the amount I need 🙂

    • Hi Natalie. I wish that was true. Unfortunately if you have no credit you will find it very difficult to get that first loan. WIth no track record most banks will want to see how you handle credit before giving you a large enough credit limit to fund a business. You will probably need to ask a friend or family member to co-sign for you. I once had a funding manager who once said to me, its better to see a client with bad credit than no credit. Why? With the bad credit person you know there is some risk in giving them credit. So you know the credit limit will be low until they prove they are now “payers” and the rate will be higher since there is a good chance the account will go into collections and a collection agency hired to take over the collections process. With someone with no credit, you have no idea how they will handle their credit. Will they pay on time? Will they pay at all??? So its just as big a risk if not bigger to extend credit to someone with no credit.

      Sorry to sound negative. I’m just concerned that you will not be able to get a big enough credit line to launch your business, and the rate might be high. You are better off apply to the SBA w/ your co-signer and getting a small SBA loan.

      Good luck!
      Suzy

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