Because lenders such as banks cannot determine the financial risk of lending money to a person by face value alone, they turn to credit agencies to provide reports on the credit history of potential borrowers. These credit reports outline previous credit activity and give a credit score reflecting the borrower's credit rating. A higher rating implies "good" credit, or higher likelihood of a borrower repaying a loan. You should determine your own credit rating before investing in a new home or car.
Origin
In 1958 the Fair Isaac Corporation started credit ratings as a way of predicting the probability that borrowers would repay their loans. Before then, someone could buy a car in one state and then buy another and another without the dealer knowing if the buyer would repay the loan in full. Now, within minutes, car dealers can look up a person's credit report and calculate the best loans to offer potential buyers, charging higher interest fees for people who are "riskier investments," i.e., those who have bad credit.
Credit Bureaus
Different credit reporting agencies receive information from lenders about the credit history of borrowers. The three leading agencies, TransUnion, Equifax and Experian, use this data to compute a credit score based on the Fair Isaac and Company (FICO) algorithms that are regularly updated. You may find out your credit score by going to one of their websites, as can any lender doing a credit check on you.
Credit Score
Your credit score reflects your credit rating. In the FICO rating system, scores go from 300 to 850, where 750 or higher indicates a good credit rating. In the VantageScore rating system, scores go from 501 to 990, where every 100-point increment earns borrowers a letter-grade of A through F. For example, 601 to 700 would be a "D," indicating a bad credit rating. Despite the differences between the value of the two scores, both rating systems work from the same formulas, where a 750 in the FICO system would be equal to a 825 or so in the VantageScore system.
Improving Your Credit Rating
A January 2008 article in "USA Today" outlined ways in which you can improve your credit rating. Because the majority of your score, or 65 percent, is based on payment history and debt, you can start by always paying on time and eliminating outstanding debt wherever possible. Start by ordering your credit score from one of the three credit agencies and see which delinquencies, if any, are affecting your credit. Also, keep your balances at or below ten percent of your available credit. High credit utilization reflects risky financial behavior to credit agencies. Lastly, maintain your credit line as long as possible. Opening new credit card accounts can lower your average credit age and damage your credit rating.
Effects of a High Credit Rating
High credit ratings can give you major perks and save you a significant amount of money over time. For instance, a 2009 "Newsweek" article examined how one individual with a good credit rating of 750 landed a two-percent interest rate over the last three years of his credit card payments. In terms of buying a house, with a credit rating of 750 or higher, you can lock in a 30-year, $300,000 mortgage at 4.5 percent, saving $14,400 more than individuals in the 700 to 750 credit rating bracket, who qualify for a 4.74 percent loan and $106,560 more than individuals in the 650 to 700 bracket, who get a 6.1-percent loan, according to the article. In other words, improve your credit rating before shopping around for a mortgage, loan or credit card.
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