How the Credit Rating System Works
The credit rating, or 'score', is used to determine how likely it is that a person will be able to pay back the loan issuer or credit card company (such as Visa, Mastercard, American Express, etc), and in what time scale, in the event the event that they borrow money (credit). In other words, it is a general beacon to show lenders and other businesses how much of a financial liability a prospective borrower is before they issue a loan.
Credit Rating numbers (based on the FICO scoring method, which is the predominant credit score system in North America) range from 300 to 850, with 850 being the highest- or best (good credit), and 300 being the lowest- or highest risk (bad credit). Most people's credit rating fall somewhere in the middle, but with a little understanding, it is easy to get good credit.
How the Credit Rating is Calculated - the Main Factors
The scoring system takes into account a number of factors, with each contributing a certain percentage of influence to the overall credit score - if a person has bad credit, read on, because this is why:
Roughly 30% of the credit rating is calculated based on outstanding debt. This means any credit cards that need to be paid, car loans, student loans, or mortgage payments that are overdue, are all negatively affecting the score. The less credit debt someone has have, the better their score.
Payment history is another major factor, representing somewhere between 30 and 35 percent of the credit rating. The longer it takes a consumer to pay their bills (or Visa), the worse this will affect their credit score. Always pay bills on time to achieve an excellent credit rating.
Other Things that Affect the Credit Rating
The rest of the credit rating is set by three smaller, but no less important factors. The first is a person's established credit. The longer someone has had credit, the higher their score will be. This is the reason that first time credit card owners are usually given a no-liability 500 dollar pre-paid credit card.
Secondly, the score takes into the account the different kinds of credit the consumer has. The more types of credit under a person's name, the better their score. For this reason it is usually better to get an approved loan rather than a second (or third, or fourth...) credit card, for those big purchases or hold-overs. Mortgages, Car and Healthcare payments, and direct debit bills are all things that will add some variety to a person's credit types.
Finally, creating new credit - such as going out and getting a handful of new credit cards - will dilute and reduce the rating, if only temporarily (depending on how many new cards are obtained and maxed out). This will actually make it harder to get good credit, in the short term. An additional penalty may be applied to the rating for hard credit checks - when a lender checks a consumer's current credit for their credit risk factor.
How to Improve or Repair Bad Credit, Easily
With a good understanding of how the credit rating is calculated, improving it doesn't seem so difficult. There are a few things that everyone can do to dramatically increase their score:
- Pay bills on time- every time. In the event that the whole bill cannot be paid, a token amount will do, and will go a long way to preventing credit damage.
- Avoid having credit checked unless it is absolutely necessary.
- Whilst it may be tempting to many people to cut up that credit card and close the account when they've finally paid it off- this is bad. The longer an account is open, the longer the credit history so the better the overall rating will be.
- Avoid maxing out credit cards for more than a a couple of months.
- Attempt to keep any credit card debt below 25% of it's limit.
Finally, anyone experiencing critical problems with their credit, or facing bankruptcy, should seek free help from groups and experts who can help them consolidate and manage their credit, and help repair their rating.