What is Credit Score and how does it work?

Jun 9th, 2020

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A credit score is an evaluation used by financial institutions to describe a loanee or consumer’s (Individual or Corporation) creditworthiness. A higher credit score depicts a reliable and credible borrower. A credit score is determined by the credit history of the borrower, which entails several open accounts, repayment history and total level of debt. Credit scores are used by lenders to determine the probability that a borrower will repay their loans.

How does Credit Score work? 

The credit score play’s a key role in a lender’s decision to give loans. A borrower with a lower credit score infers that a financial institution bears more risk loaning such borrower. A high credit score is considered good as it makes the interest rates of loans reduce; and also makes the application process for a letter of guarantee easy. Therefore, a high credit score may result in a loanee receiving lower interest rates on a loan. 

Sometimes credit scores are also used to determine the size of an initial deposit required to get several kinds of loans. Lenders also used credit scores in deciding the interest rate or credit limit on a credit card.

In Nigeria, the credit scores of financial institutions will vary depending on the institution. 

Factors that affect Credit Scores

We’ll look at 5 factors to consider when calculating a credit score, they are:

  1. Payment History: This amounts to about 35% of how a credit score is evaluated. It shows whether a person pays their obligations on time such as bills. It is used to determine the possibility of a borrower whether they will be late in repaying their loans based on how promptly they settle bills.
  1. The total amount owed: This is the second most influential factor of the credit score. It amounts to 30% of the credit score. It refers to the percentage of available credit that has been borrowed by the loanee. It is used to determine who can handle debt responsibly. 
  1. Credit History: The credit history is used to examine the length of the time an account has been opened and the most recent action on an account. Accounts with a long credit history stand will score higher credit scores than accounts with minimal or no credit history at all. Those without a long credit history can still score higher on their credit scores if there are no missed payments and outstanding debts. 
  1. New credit: New credit refers to the number of credit accounts a borrower has. Lenders often carry out a credit report on borrowers. A borrower who as opened credit accounts and applied for too many loans will score lower on the credit score. 
  1. Types of credit: Types of credit also known as the credit mix is used to examine borrowers with a good mix of account types involving credit and instalment loans. A borrower with an existing credit account demonstrates experience in managing credit and may likely score higher credit score.

How to Improve your Credit Score

Make payments on time

Endeavour to make your payments on time, and if you have down payments to make.

Review of Credit Reports

Reviewing your credit reports helps to know what is benefiting you. You can request your credit report from your financial institution, then you can run a personal assessment to see what may help or potentially hurt your score.

Use Credit Monitoring to Track Progress 

Using credit monitoring services is a simple way to monitor credit score changes over time. These services monitor changes in your credit report, such as a paid-off the account or a new account opened.  Credit monitoring also helps to prevent identity fraud.

Limit Request for Credit Inquiries

The number of requests you make for new credit should be minimal. Too many requests for credit is known as hard inquiries. For example, if in the past you’ve requested for a new credit card loan, car loan, mortgage loan or some other form of a loan, it can negatively affect your score. A lender could interpret the borrower is facing financial difficulties and therefore be a bigger risk to the lender.

Pay off Debts and maintain a low balance on Credit Cards.

Borrowers with high credit scores often have very low credit utilization ratios. A low credit utilization ratio illustrates that you aren’t in debt and haven’t maxed out your credit cards. It shows that the borrower is likely to know how to manage credit well as lenders can be wary of loanees with low credit scores.

Diversify accounts

You may consider opening new accounts to add to your credit mix.

Conclusion

A good credit score makes a lender consider you highly for a loan in Nigeria. It also helps you get the best interest rates when you intend to loan. Since you never can tell well you might be needing a loan, it is wise to ensure that you’re as good as possible by regularly checking your credit report, having a positive payment history, having low balances on your credit cards and minimal inquiries for credit. 

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