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Credit scores are very important in America’s financial system, but maybe not for the reasons you think. Understanding the real value of credit scores may give you a different perspective on them.
Credit scores are important to lenders and borrowers. Calculated based on information in credit reports, credit scores can be a useful measure of a borrower’s credit status. For that reason, credit scores help lenders choose who to lend to, how much they can lend, and what they should reasonably charge to balance the risk of a borrower not paying the lender back. Here’s a closer look.
Lenders who use credit scoring can get a more precise picture of a borrower’s creditworthiness. And because credit scores assign number ranges to represent credit experience, they help level the playing field for everyone.
Credit scoring evaluates only certain facts related to credit risk. Five factors — payment history, amounts owed, length of credit history, credit mix and new credit — combine to make up the three-digit FICO® Score number, for example.
By law, factors such as gender, race, religion, nationality and marital status can’t be considered when deciding to extend financing and set terms. What’s more, if you’re ever denied credit, you also have a right to know why.
It is inevitable that some people will run into issues that will prevent them from repaying their loans and there is no way to know who will face these issues. Therefore, lenders use credit scores to determine how many loans in a given group are likely to go unpaid. Because credit scoring assesses risk, it can give lenders a better understanding of the types of credit and terms they can offer.
Why does a credit score matter? Credit scoring determines what types of credit you qualify for. Knowing when a credit score may be reviewed can give you a sense of the role it can play in your financial life. Here are four areas that a credit score may influence:
Credit scores and credit reports influence the ability to rent an apartment or buy a home. Landlords and property managers may review potential tenants’ credit history as part of a rental application and security deposit.
And mortgage lenders will broadly evaluate credit in order to qualify borrowers for a mortgage loan and set an interest rate for the loan term. Securing a competitive interest rate is important because lower interest rates mean you’ll end up paying less over the life of the loan.
Just like for mortgages, credit scores and credit reports also guide lender approvals and interest rates for auto loans and leases, as well as personal loans or line of credit.
Car dealerships and their bank partners, for example, may use a slightly different form of credit score that’s specific to the auto industry when considering applications for financing. In addition to the car loan approval, interest rate and monthly payment, this information could also influence the down-payment amount or, in the case of leases, the types of vehicles available to you.
Whenever you apply for a credit card, the credit card issuers will use credit scoring to decide whether or not to approve your application, and the credit limit and interest rate it can offer you. Your credit score may also come into play if you’re trying to upgrade to a new card or requesting a higher credit limit on an existing card.
Insurers in many states rely on what’s known as a credit-based insurance score, a similar type of credit reporting that, along with other factors, helps predict an applicant’s likelihood of filing insurance claims.
According to the Insurance Information Institute, research has found a relationship between these types of insurance scores and the cost of claims filed for both auto and homeowners policies. So, insurance companies may consider this information in deciding whether to offer you a policy and the insurance premium amount they charge.
There are plenty of important situations where credit scores matter. But there also are many instances where they don’t. Here are two misperceptions that you should keep in mind.
It’s not uncommon for some consumers to feel like credit scores reflect whether they’re judged to be “good” or “bad” people based on excellent credit vs. poor credit. This is untrue. Credit scores are relative only to your past financial situation as it may relate to the future; they aren’t a measure of positive or negative personal attributes.
In fact, credit scoring models compare the information on your credit reports to the credit behavior of people with similar credit profiles when they assign scores. And these three-digit numbers simply summarize statistical risk for lenders — so that they can focus only on the facts and not on personal judgments.
The terms credit score and credit report are sometimes mistakenly used interchangeably, and that tendency has led to the misconception that employers can reject job applicants because of their credit score. The fact is, credit scores aren’t used for employment screening purposes. Credit reports might be, but in a limited way.
If employers ask for your consent to review your credit report, they won’t see the same information that lenders do. Instead, they receive a modified version that doesn’t include your credit score. They may review your debts, payment history, employment history, or other information. Such credit checks are most often used after a hiring decision has been made and if there is anything concerning found, your potential employer could ask you to explain or rescind the offer of employment.
Credit scores are influential tools, which is why they’re important to you. But they don’t have to permanently dictate your financial future.
It’s true that having a higher credit score means lenders will see you as less of a financial risk, and that can mean you’re more likely to get better credit and pay less for it. So, striving to maintain or improve your credit status is a wise financial move.
But it’s also helpful to think of a credit score as a snapshot in time. After all, it’s based on data in your credit report at the time it’s requested. So, credit scores change when the information in the credit report changes. More importantly, the most recent information on the credit report is usually the most important in your score.
A credit score is a financial decision-making tool that’s used during moments in time. And it’s really only one measure of who you are as a borrower. To keep things in perspective, instead of fixating on the score itself, focus on the good habits that help overall financial health — and let the score take care of itself. For example:
The bottom line? A record of sound financial habits and time will have the greatest impact on your credit score. And you are in control of your financial future. Now that you’ve gained some perspective on how credit scores are used and when they matter, get more details about how credit scoring works, and take our Score40 Quiz to discover ways to improve your credit score.