Understanding The Importance Of A Good Credit Score

By MySpendingPlan.com Editorial Staff

A credit score is a numerical representation of your credit history and your credit worthiness.  When you approach a lender for a loan, be it a new credit card, a home mortgage or a car loan, the lender has to judge how big a risk you are when it comes to repaying the loan.  They want to judge your credit worthiness, which helps them to decide whether they should approve your loan application or not.  And they do this on the basis of your credit score.  Believe it or not, many insurance companies and employers now check your credit score, which can impact your chances of getting a low insurance premium or the job you want!

The income you earn is certainly part of the lending decision, but your credit score trumps all – there are actually millionaires out there who cannot get even a credit card because they have bad credit or lack of credit history.  Luckily for them, they are millionaires.  The rest of us have to make sure we monitor our credit scores.  We explain it below.
 

Credit Score Explained

There are many credit reporting bureaus in the US, of which the three main ones are Experian, Equifax and TransUnion.  These bureaus maintain a credit file of every person who has ever borrowed any kind of credit.  All your credit information, bank account information, loans, payments, etc. is contained in the credit file.  On the basis of this information, a credit score is calculated.

Although there are many different types of credit scores, the most important is the FICO credit score.  This is the credit score that is used by the 3 leading credit bureaus in the country and it is also the credit score which the majority of the lenders look at to determine your credit worthiness.

About FICO Credit Score

The Fair Isaac Corporation (FICO) first developed the formula to calculate a person’s credit score based on their credit information.  Since then, the FICO credit score has been accepted as the most official credit score in the US.  Although there are other credit scores, none come close to the FICO score in terms of authenticity, correctness and nationwide acceptance.

A FICO credit score is a three digit number which can be anything between 300 and 850. A score in excess of 760 is considered to be an excellent credit score. Scores ranging from 700 to 759 are good, those ranging from 650 to 700 are average, and below 650 are low credit scores.

Impact of Credit Score on Borrowing Capacity

As mentioned previously, the only way for lenders to judge your credit worthiness as a borrower is to check your credit score.  If you have a high FICO score, you will be able to get loans at the lowest possible interest rates and without too much paperwork involved.  If you have an average FICO score, you will attract interest rates that are in the mid range and will have to go through additional paperwork.  However, if you have a “bad” FICO credit score (less than 650), you will find it extremely difficult to get any kind of credit. And the loans that you do manage to get will be at extremely high interest rates. 

Here’s an example to explain this better:

As of May 2006, a person with a FICO score of 760-850 can get a mortgage loan at 6.29% interest rate.  However, the interest rate rises to 6.69% for someone with a FICO score of 680-699, and even further to 7.88% if your credit score is about 620-639 (figures taken from myfico.com).

Thus, as you can see, just by having a good credit score, you can get interest rates that are 1.5%-2% lower than if you have a bad credit score.  For a mortgage loan of about $200,000, this could translate into a saving of thousands of dollars over the period of the loan!

Therefore, to get credit at low rates and good terms, it is important that you maintain a high credit score.  By monitoring your FICO score regularly (use MyFICO.com tools), you will know exactly what your credit score is and can take the necessary steps to increase it, if need be.