(March
29th, 2007)
Upon borrowing money and taking out credit,
you are promising to pay back to the lender the original principal you borrowed + some interest fees after
a certain period of time. How likely is it that
you will pay back this debt you owe? To determine this,
the FICO score was developed. FICO is a software that calculates your credit score
and your risk levels of default, created by Fair
Isaacs Corporation.
Your Credit score is determined
by your Credit Bureau. Some of the factors involved in
calculating your credit score include:
-
History of your credit payments (whether
you have been paying on-time or delinquent)
- Your current total outstanding debt
- Frequency of applications for new credit
- Time length of credit history
Credit scores vary between 350 (very high risk)
to 850 (very low risk). In the graph below, we show the average
credit scores of Americans in 2003.
Apart from using the FICO credit scoring system,
most Credit Bureaus in US and Canada use a rating scale of 0-9
to rate your personal credit. In the following table:
- "I": Stands for
Installment Credit example home mortgage or auto financing loan.
- "R": Stands for
revolving credit example Credit Cards.
| Rating |
Description |
| R0 ; I0 |
You are a newbie to Credit
and there is no sufficient information to assign you a credit
score. Therefore, you might just qualify for a $500 limit
credit card to start building your credit history. |
| R1 ; I1 |
Pay back debt in 1 month |
| R2 ; I2 |
Pay back debt in 2 months |
| R3 ; I3 |
Pay back debt in 3 months |
| R4 ; I4 |
Pay back debt in 4 months |
| R5 ; I5 |
Have not paid your debts in
4 months |
| R7 ; I7 |
Your debt payments are under
consolidation |
| R8 ; I8 |
Your debts were cleared by
repossesing the items you purchased, and selling them at FMV
(fair market value). |
| R9 ; I9 |
You are classified under Bad
Debt Expense and your debt is deemed uncollectible. You therefore
may be denied any future credit. |
Components of Your Credit Score?
The 5 components that make up your Credit Score
include:
- Previous Credit payments & performance
history
- Current debt load
- Your past average credit length or history
- Types of credit available to you
- Your applications for new credit
In the graph below, we summarize the importance
of each of these items in percentage format, with the total being
100%
From the above graph, you can decipher
that keeping a good history of regular on-time payments will help
you increase your credit score. Furthermore, keeping a low debt-load
and not maxing out your credit cards also increases your credit
score. Additionally, not making frequent credit applications but
keeping your current credit history alive and in good performance
will help you raise your credit score.
Credit Score and its Impact on
Monthly Debt Payments
If you have a bad credit score,
this means you are at an increased risk of defaulting on your
debt payments. Some lenders might reject your application, while
other lenders will offer you debt financing, but at higher
interest rates. This is opposed to someone with a good
credit history who will be offered debt financing, at lower
interest rates. Therefore, the person with a bad credit
history will have to pay what's called a "Risk Premium." Here is a sample data table taken from www.myfico.com It shows your credit score level, the interest rate you will be
charged and subsequently your total monthly payments.
| Credit Score |
Interest Rate |
Monthly Payment |
| 500 - 559 |
9.29% |
$1,238 |
| 560 - 619 |
8.53% |
$1,157 |
| 620 - 674 |
7.30% |
$1,028 |
| 675 - 699 |
6.15% |
$914 |
| 700 - 719 |
5.61% |
$862 |
| 720 - 850 |
5.49% |
$814 |
