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Credit Scoring Explained

in Banking, Blog, Credit Cards, Current Accounts, Loans, Mortgages

Whenever you apply for a loan or a mortgage, or any other type of credit arrangement such as a mobile phone contract, the lender will want to know if you are able to repay the debt. To seek clarification on this point, they will – besides asking you numerous questions – apply to a credit ratings agency (CRA) for details of your credit score.

Think of your credit score as a barometer of your financial health. A high score means that you have an excellent credit record, and will likely result in you paying a low interest rate. On the other hand, if you have a low score, that will translate into higher interest rates and, maybe, even a rejected loan application. Since the recession, lending institutions are relying ever more heavily on credit checks, so it pays to know how the system works.

So how does credit scoring work?

It’s really quite straightforward. Points are awarded for your past financial performance. If you have a history of paying bills on time and never miss a payment, the CRA will likely assess you as a good credit risk. Lending institutions, such as banks, will then use your credit score and combine it with the data that they have gathered on you, to assess your loan worthiness. If your score is above a minimum level set by the lender, chances are that your application will be approved.

How can I improve my credit score?

1) Credit ratings agencies love stability. If you’ve been in regular employment for some time, this is a big plus point. So is owning your own home, rather than renting. And it pays not to move too often. If you have the kind of job that requires frequent changes of address, you can expect to have a lower credit score than someone in similar financial circumstances who has lived at the same address for several years.

2) Wherever you live, you need to ensure that you are listed on the Electoral Roll. This is vital. Lenders will use this information to confirm your current address. If, for any reason, your name is missing from the Electoral Roll, it will count against you.

3) Make sure that you pay all your bills on time. Even a single late payment can have an adverse affect on your credit rating.

4) Don’t overload the plastic! Keep an eagle eye on your credit card usage. If you attempt to exceed your limit, expect a downgrade on your credit worthiness. And if you really want to be on the safe side, don’t get too close to your limit. It is believed that some CRAs regard this as an indicator of impending financial troubles, and that might flag a warning on their databases.

5) Limit the number of credit searches that you make. For example, CRAs take a dim of view of someone who applies simultaneously for several credit cards, as such multi-applications are interpreted as a sign of potential financial desperation. Bear in mind that searches remain on your credit record for two years.

6) Oddly enough, someone with a high level of debt, but who repays in full and on time, is likely to have a higher credit score than someone without any debt whatsoever. This is because the former has a proven record of repaying a debt, while the latter is an unknown risk. And one thing that CRAs and lending institutions loathe is the unknown.

The two largest CRAs in the UK are Experian and Equifax. Although these agencies are cagey about their scoring methods, they are obliged to provide a copy of your credit record if you request it (there is generally a small fee for this). Check the report carefully, and, if you find even the smallest mistake, contact them immediately. Failure to do so could have a disastrous effect on your credit score.