All about the credit rating
A credit rating, in simple terms, is an estimation of how likely you are to repay a debt. Credit is where you are given money or something for value even before you pay for it. For instance, you use a credit card to spend money and then pay for it a later date. A loan that you take is also an example of credit. You get a sum of money for your use and you repay it at a later date. When someone lends you money, they do it to earn interest on it. If you don’t repay the money on time, it puts the lender in trouble.
So lenders would like to know if it safe for them to lend to you. Based on your past record of spending and repaying debts, it is possible to understand if you can be relied upon to repay debts on time. This is the concept behind credit rating. Usually, a third party would compile data about your financial activities and based on that rate your credit-worthiness. The rating would tell a potential lender whether you are worthy of receiving credit. Higher the rating, the more reliable you are in repaying loans.
A low rating, on the other hand, indicates that you are a credit risk. This means if someone lends to you, there is a possibility that you may default on your repayment. No lender would like to take a risk of someone defaulting on debts. A default leads to having to follow-up for payment and taking legal action. To avoid such a messy situation, lenders would not lend money to those who have a low credit rating. Alternately, they may agree to lend money, but impose a number of conditions.
Individuals are provided with a credit rating or a credit score by rating agencies. The rating system usually awards points based on previous financial transactions, whether you pay interest on time, how many times you default, etc. Based on all this, you are given a rating or score, which is referred to as a credit score. This score determines your credit-worthiness. When you approach a bank or a lender for credit, they would refer to your credit score, based on which they would decide whether to give you credit or not.
Your credit score is determined by many factors. One of the well-known credit rating agency is FICO. Their ratings or score is determined as per the following weightage:
- 35% for your history of past payments
- 30% for the debts that you have
- 15% for the duration of your credit history
- 10% for new credit and new accounts
- 10% for the various types of credit that you use
When you apply for a home loan, the credit score plays an important role in deciding whether you will get the loan or not. It also decides the terms on which you get the loan. The higher the credit score, more favorable would be the terms. It is in your interest to have a good credit rating. There are two scenarios here. One is that you are starting off fresh, probably after college. In this case, you would like to ensure you develop a good credit rating and keep it that way.
The other scenario is that you already have debts and your credit score may not be satisfactory. In this case, you would like to do something to improve your credit score. In either of the scenarios, you would need to work to build a strong credit rating. We will tell you how to build and improve on your credit score so that you would be rated as being more credit-worthy.
- Think before you take credit
It is easy nowadays getting credit as compared to some years back. The credit card is the classic example, where banks queue up to offer you a credit card. With a credit card in hand, you are tempted to spend money. You even start spending money to buy things you don’t need. Only when the bills start arriving, you realize that you don’t have the money to repay the lender. This puts you in a difficult situation. Failure to repay bills on time will lower your credit score. So, the first thing you need to do to have a good credit score is to think carefully before you avail of credit. If you have the money on hand to repay it or are in dire need of the purchase, only then go ahead.
- Have a budget
This is a simple thing to do. Make a budget that lists out all your earnings and all your expenses. This helps you ensure you don’t spend more than you earn. It also helps you to make a list of all that you are planning to spend for the month. You would know in advance what you are going to spend on and whether you would use your credit card for the same. This is a disciplined way of spending that helps you to spend money wisely.
- Clear your bills on time
Your bills will arrive promptly every month. It is your duty to clear them on time. This is the best way of having a good credit score. Repay each and every bill on time. This ensures that you are financially disciplined. It allows you to manage your finances better. It also helps you build a good credit score. Remember that it is not only bank loans and credit card bills you need to pay on time, but all bills. Even if you default on utility bill payment, you can be reported to the credit agency.This can lower your credit score.If you get a bill that you are not able to pay, it means you have spent more than you can afford. This is a cardinal mistake. Spend on what you can afford and pay the bill on time to build a good credit rating.
- Don’t use up your entire credit limit
When you get a credit card, you would be given a credit limit. This is usually done based on your income and other factors. Just because you have a credit limit of 60,000, it doesn’t mean you utilize the entire amount. Never use your full credit. To be financially disciplined, you need to restrict your balance to 30% of your credit limit. This means, for a credit limit of 60,000 your balance due should not cross 18,000. This is a good way of keeping your debts less, helping you to pay it back on time.
- Setup automatic payments
Discipline is very important when managing your finances. Even though you have money, you may decide against repaying your credit card bill in full. A disciplined way of bill payment is to setup auto payment for bills. Ask your bank or card issuer to automatically deduct the bill payment from your bank account and give them the authorization for the same. This will ensure that your bills are paid on time. It will also make you cautious.If you don’t have money, you will think twice before spending. This is a great way to build a good credit rating.
- Use a secured credit card
This is useful for those who are starting from scratch. A secured credit card is given after you make a deposit. This deposit is usually equal to the credit limit offered to you. This makes the card secure for the issuer as even if you default, they can take the money from your deposit. You would also be careful while spending money, as you know that you have paid a deposit on the card. It is important that when you get a secured credit card, it is reported to the credit rating agency. This helps you to establish a good credit score.
- Start with only one card
There is a great temptation to have more than one credit card. This would give you the option of an enhanced credit limit. Further, each card comes with its own benefits, like reward points, discounts, etc. The more the cards you have, the greater is the chance of building up a huge debt that you can’t repay. This, in turn, affects your credit score. You must know that every time you apply for a credit card, the issuer would make an inquiry to the rating agency.
Such inquiries would reflect in your credit score report. If you have too many such inquiries, it can create a perception that you are desperate for money and are looking for it from different sources. While it may not reduce your credit score, a lender may think twice before lending to you. Avoid the temptation of getting multiple cards. When you start, have only one card. Once you build a satisfactory credit history, you can then think of additional cards.
- Don’t close credit accounts
The credit score system is in favor of those with a credit history of long standing. The longevity of your credit history reflects on your credit score. Closing credit accounts will not help in your quest to get a good credit score. It would be advisable not to close a credit account. The age of your credit accounts is one of the factors deciding your credit score. So, allow your credit accounts to age, even if you don’t use it.
- Your job also counts
If you don’t have a job or keep changing jobs very frequently, it can create a bad impression on a lender. Your job history will not be reflected on your credit score. A lender would not lend money solely on the strength of your credit score. They may also consider other factors like employment history. If you have a reliable work history, then it may convince them to approve your loan application easily, even if your credit score is borderline.
- Check your credit report
This is something most people don’t do. It is important to check your credit report and see what is there. It is possible that there could be mistakes in the report. If so, you need to get them rectified immediately. Any mistake in the report would affect your credit score. There are other problems like credit card fraud and identity theft that can have an impact on your credit report and credit score. Regularly scanning through your credit report helps you identify such things. You can then contact the rating agency and get the report corrected.
The credit report also helps you know your outstanding bills. It is possible that you have forgotten about a bill and the lender has also not pressurized you to repay it. Finally, it ends up on your credit report as a liability and can affect your credit score. Regularly monitoring your credit report helps you identify such bills, so that you can clear them and be debt-free.
- Look for a credit builder loan
A credit builder loan is given for the specific purpose of helping you build your credit. This is a great way of improving your credit score. The amount you borrow would be in a bank savings account, where it earns interest. You would usually get a better interest rate for a credit-builder loan. Pay off the monthly installments on time and this is reported to the credit bureau. This helps create a credit history and also helps you establish yourself as being credit-worthy. Once you repay the loan, the money in the bank with interest is released to you. Such loans are offered by credit unions and other organization.
- Become an authorized user
Young people can opt to be an authorized user of their parent’s credit card. This will help them get the advantage of the good credit their parent has. This is a good way to get started in establishing credit.
Building a good credit rating is important. It can be done easily if you are financially disciplined and follow the guidelines given here.