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Cracking the Credit Score Code: Your Ultimate Guide to Understanding Credit Scoring – Prof. Raveesh R

1st July 2024

Lenders and other financial organisations use credit scoring, a statistical study, to assess an individual’s or a small, owner-operated business’s creditworthiness. Lenders use credit rating to make decisions about granting or refusing credit. Your eligibility for financial goods such as credit cards, mortgages, auto loans, and private loans may be impacted by your credit score. You may be able to get a credit card or loan with better terms and a lower interest rate if you have a high credit score. Nevertheless, different lenders determine who to lend to and at what rates based on their own standards. Find out more about what makes your credit score higher, what affects it, and how to raise it.

A Good FICO Score: What Is It?

Different consumer credit score kinds are produced by FICO. The company creates industry-specific credit scores for credit card issuers and auto lenders in addition to “base” FICO Scores that lenders across several industries can utilise. The credit score range for industry-specific FICO reports is different; it is 250–900. The intermediate categories, on the other hand, are still grouped together, and a “good” industry-specific FICO® Score still ranges from 670 to 739. The ways in which different credit scoring models assign scores may vary slightly. More than 90% of leading lenders utilise Fair Isaac Corporation’s credit scoring system, popularly known as a FICO score, making it the most extensively used credit scoring system in the financial sector.

However, TransUnion, Experian, and Equifax—the major three credit-reporting agencies—created VantageScore, another well-liked credit scoring model.
A FICO credit score ranges from 300 to 850, where 850 is the maximum score that may be obtained. Small business credit scores, such those provided by the FICO Small Business Scoring Service (SBSS), vary from zero to three hundred.

Five categories have an impact on a credit score:

History of payments (35%).
Amounts due (30%)
Credit history length (15%)
Fresh credit (10%)
Mix of credits (10%)

The data in a small business’s credit report, such as the following, determines its credit score:
Details about the company, such as the number of workers, sales
Past corporate information
Details of business registration
A summary of government activities
Operational business data
Data and classification of industries
History of payments and collections
Quantity of accounts, information, and reports

Credit scoring is used by lenders in risk-based pricing, wherein the terms of a loan, including the interest rate, are offered to borrowers based on the likelihood that they would repay the loan. Generally speaking, the financial institution offers better rates the higher the credit score.

Information Not Taken Into Account by Credit Scores
When determining credit scores, FICO and Vantage Score do not take the following data into account:
Your gender, marital status, national origin, race, colour, and religion. How old you are.
Your income, profession, title, employer, length of employment, or previous jobs. However, bear in mind that lenders could take this information into account when determining whether to approve an application overall.  Soft inquiries are typically started by other people, such as when businesses extend promotional credit offers or when your lender regularly examines your current credit accounts.

The Limitations of Credit Scoring

 Credit scoring does not determine the probability of a default; rather, it rates the borrower’s credit riskiness. It simply assigns a risk rating to each borrower, ranging from highest to lowest. Thus, credit scoring suffers from its inability to determine if Borrower A poses twice as much risk as Borrower B. Another interesting shortcoming of credit scoring is its inability to precisely account for the status of the economy. For instance, if Borrower A has an 800 credit score and there is a recession, Borrower A’s credit score won’t change unless they have a change in behaviour or financial circumstances.

FICO created the FICO Resilience Index in an effort to remedy this disadvantage. Experian claims that it “is intended to evaluate consumers regarding their resistance or susceptibility to a downturn in the economy and offers insight into which consumers are more likely to default during times of economic stress.” It can be supplied with a credit file together with the FICO Score and utilised by lenders as an additional factor in credit decisions and account strategies throughout the credit lifecycle.

Default probability is determined using more sophisticated credit risk modelling techniques, such as structural models and reduced-form models. Technological developments like machine learning and other analytics-friendly programming languages are improving credit risk modeling’s accuracy through scientific means.

Ways to Raise Your Credit Ratings
Concentrate on the fundamental causes of your credit score fluctuations if you want to raise them. The fundamental actions you must conduct are, in general, rather simple:

Pay down all of your debts on schedule

Even if it’s just the minimum amount due. Your credit scores can be negatively impacted by even a single late payment, which can remain on your record for up to seven years. Get in touch with your creditors as soon as you suspect you might miss a payment to see if they will work with you or provide hardship solutions.

Maintain a modest credit card balance

When comparing the credit limit and current balance of revolving accounts, such credit cards, your credit utilisation rate plays a significant role in the scoring process. Your credit ratings might be raised by having a low credit utilisation rate. The overall utilisation rate of those with great credit is typically in the single digits.

Open accounts that the credit bureaus will be notified about

Make sure that any new credit accounts you open will appear on your credit report if you don’t have many credit accounts. These could be revolving accounts like credit cards and credit lines, or instalment accounts like student, vehicle, home, or personal loans.

Apply for credit only when necessary

A hard inquiry resulting from a new account application may slightly lower your credit ratings. While the effect is usually negligible, applying for a lot of different credit cards or loans in a short amount of time may result in a higher credit score decline.
Your scores may also be impacted by other variables. For instance, raising the average age of your accounts may improve your ratings. But more often than not, that requires waiting instead of acting.

Bottom line

You may be able to learn more about how to raise your credit ratings by checking them. For instance, you can see how you’re performing in each of the credit score categories when you check your free Experian FICO Score.

To raise your credit score, you can take action. These include of paying your bills on schedule, lowering your debt load, and maintaining a balanced credit mix that includes both revolving and non-revolving loans. Your credit score is also influenced by the duration of your credit history, so try to avoid terminating accounts.

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