What is a credit score?
A credit score is a number that depicts a consumer’s creditworthiness. It is the most important measure of a person’s financial health and is therefore, a widely used indicator worldwide.
Essentially, the better a person’s credit score is, the easier it is for him/her to get credit from various financial institutions. It also determines the interest rate available at the time of borrowing. Therefore, maintaining a healthy credit score really eases the path to financial freedom for an individual.
With an attempt to improve one’s credit score, this blog discusses simple yet effective methods of doing so.
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Credit Bureaus and Credit Rating Models:
It is generally assumed that there is just one standard credit score applicable, but this is usually not the case. Different countries have different credit scoring models that essentially determine a score to gauge the creditworthiness. Even though the fundamentals governing these credit scores are the same, the relative proportion of these fundamentals and the scale used differentiate one credit score from the other.
There are organizations called credit bureaus which are responsible for the compilation of credit reports and credit scores which are eventually used by lenders. In the United States, the three national bureaus of national significance include Equifax, Experian and TransUnion.
These bureaus use various credit scoring models, of which, the most commonly used and widely accepted is the FICO Score, which was developed by Fair Isaac Corporation in as back as 1956. It however was only made available to consumers in 1989. The FICO score is a three digit number ranging from 300 to 850. Typically, a score in the range of 670 to 739 is considered a good credit score, helping secure loans easily and at suitable interest rates.
Another widely used scoring model is the VantageScore, created by the three major credit bureaus in 2006 as an alternative to the FICO Score to better address changes in behavioral trends and advances in data collection. The most current versions of VantageScore have the same range as the FICO Score (300 to 850).
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Factors determining credit score:
Regardless of the credit bureau and the credit rating systems used by these bureaus, there are certain intrinsic factors that determine the credit score of an individual consumer. These factors need to be understood in order to understand the various methods that can be employed to improve one’s credit score.
Payment history: This takes into consideration on-time payments.
Amounts owed: This measures how much debt an individual is carrying relative to his/her credit limits.
Length of credit history: This measures the duration for which the individual has been handling credit.
New credit: This measures the frequency of application of new credit.
Credit mix: This measures the ability of a consumer in handling different types of credit including credit cards, loans, etc.
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5 Ways to improve credit score:
In order to improve one’s credit rating, one can systematically follow the ways written below which seek to improve upon the factors affecting the credit score listed above and thus, provide a consumer with an edge over other consumers, providing him/her with a better credit experience over a longer period of time.
Build a Credit File:
The first and the most obvious way of improving a credit score is by creating a timely credit file. It is essential for a consumer to open new accounts accepting credit from various credit lines right from an early age in order to build a reliable credit profile over time.
In order to lay down a good track record as a borrower in the future, it is required to open accounts in one’s name in the present and this is the first step towards building a good credit score as well.
Once an account is opened with a lending institution, they report the same to all the major credit bureaus.
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Make Timely Payments:
Being disciplined and punctual with repayment of outstanding debt is one of the most important methods of steadily improving credit rating and maintaining a good credit rating score.
As can be understood intuitively, a lending institution would like it's payments to be done timely in order to maintain a healthy balance sheet from time to time. No institution wants any delays in its payments since it loses out on the time value of money or the value generated by the money had it been returned timely.
Due to the inconveniences caused to the lending institution due to delays in payments, the borrower delaying payment suffers monetary penalties along with a downgrade of credit rating with time.
An individual looking for a decent credit score needs to put in measures in place to remind him/her of making timely EMI payments and form a habit of doing so. These measures can include notification systems or automatic payment systems.
Usually payments that are at least 30 days late can be reported to the credit bureaus and can end up hurting a consumer’s credit scores.
Keep Track and Catch Up on Past-Due Accounts:
Another seemingly obvious yet effective method of reaching a good credit score is to keep punctual checks on the past-due accounts, these could include past credit cards or loans including house loans or vehicle loans, etc.
While a late payment can remain on a person’s credit profile for as long as seven years, it accrues up late payment charges over time and puts a dent on the credit history and corresponding the credit score of the individual as well.
So, if for some reason, payments have been delayed, the reason should be conveyed to the lending institution at the earliest and the combined payment Including the initial amount and the late fee should be gotten rid of as soon as possible.
Additionally, a punctual analysis of old credit cards should be done and only if the bills can not be paid anymore should the card be discontinued, after settling the remaining dues. It is a general practice of people to switch between credit cards and then discard the previous ones. While this might seem enticing in the short term, it has a detrimental effect on the credit rating over a longer period and therefore, a detrimental effect on the long term financial goals of an individual.
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Customize Credit Limit:
A consumer’s credit utilization rate or credit utilization ratio is the amount of revolving credit being currently used to the total amount of revolving credit available to the consumer.
The credit utilization rate has a significant impact on a person’s credit score. In general, the lower the credit utilization ratio, the better the credit score.
Utilizing the credit to the fullest has a negative impact on the credit score since it fails to provide the lending institution a buffer and increases the amount of loss if the borrower defaults in his/ her payments.
A good practice is to customize credit limits based on expenses after discussing with the lender.
Limit applying for new accounts and taking too much debt at a time:
The amount of accounts opened in a particular period of time and the number of loans taken in a fixed period of time should be kept to a minimum to improve credit score.
An individual should repay one loan and then take another if keeping a good credit score is a priority for that individual. This is primarily because if a person takes multiple loans at once, it becomes evident that the person is in an unforgiving cycle of insufficient funds, hinting at the continual of the behaviour in the future as well. As a result, his/her credit score may fall.
Also, each loan application leads to inquiry and a coupling of several inquiries can have a negative compounding effect on credit scores. The inquiry aspect is often overlooked when constantly applying for loans.
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The Bottom Line
This blog discusses the 5 key ways to improve an individual’s credit rating. Almost all of the 5 methods discussed are intuitive in nature and do not need any sort of deep financial understanding to understand.
The key aspect however remains in the implementation part of the methods. Reaching to and more importantly maintaining a decent credit score is a slow and steady process. It does not happen overnight and therefore, the sooner the journey begins, the better it is.
The journey of improving the credit scores involves more of a consistent approach rather than a smart one and therefore, can easily be adopted by anyone.
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It needs to be understood that lending institutions need creditworthy borrowers as much as borrowers need trustworthy lending institutions for their financial requirements. The process is therefore both ways and sometimes takes longer than expected but success is guaranteed with small steps and consistent efforts.