There's a lot of misunderstanding around credit scores and how they are calculated. So, to make things easier, here's our guide to the impact they have on any applications you make, and even on the rate you pay for existing loans.
What is a credit score?
Many lenders try to calculate how reliable you will be if they lend you money. This is based on a variety of factors, including whether you have paid back other creditors as agreed in the past.
Lenders try to assess and quantify the risk of not getting their money back on time and put a number on it – this is your credit score.
Is there one universal score?
Many of us believe we only have one credit score. But in fact, each organisation will rate and rank information according to its own criteria and experience. If you’ve applied for credit with a particular lender, your credit score is decided by that lender.
A credit reference agency, which holds your credit report, may formulate its own score based on what it has in your file – but it's just that – its own score. A credit agency score may give you some insights into how you will fare when a lender looks at your file, but it isn't a guarantee of your final score as calculated by the lender when it reviews your application.
All this means is that you don't have just one credit score - and there is no such thing as a shared blacklist between lenders of people who won't be offered credit. The advantage of this is that, just because one lender has rejected you, it doesn't automatically mean that another will.
How is your score calculated?
To work out your score, lenders look at both your application and the information in your credit report.
Based on what’s in your application, they will take account of your job and how long you have been working there, what you are paid and how much you have left to spend after outgoings. They will also look at your credit report from the agency they use – they may only use one of the three main agencies.
Lenders assign points against the information you've given them and calculate your rating from that. They may give more weight to some aspects of your credit history than others, which will also be factored into the formula they use. The total is your credit score.
For example, in looking at your credit report they may consider the number of times you have missed a payment, and give that a much stronger negative score than making a late payment.
In general, the higher the score, the more likely you are to be a good risk for a company to lend to and be able to pay back what you borrow. You may also be offered a more competitive rate of interest with a higher score, too.
It might be a relief to learn that the previous occupants of your address can't affect your credit score.
How do lenders use credit scores?
Lenders use your credit score to try and predict how likely you are to pay back what they lend you, based on how you have behaved in the past and your current circumstances. They will set a formula and a minimum credit score or threshold for applicants to be eligible for the particular kind of credit you are applying for.
The same lender may even apply different formulae for different products – which could mean you get different scores from the same lender if you apply for various products. So you might be accepted for an overdraft or for a mobile phone, but have a request for a loan turned down.
If you score under a lender's threshold total, it may decide not to lend you the money, or it may charge you more to do so. Some lenders specialise in loans for riskier customers and may offer credit where another bank might not.
Lenders don't have to tell you what your score is or how they worked it out – but they should give you a basic explanation of how scoring works, and whether your application has been refused because of your credit score or your credit report. They should also tell you which agency was used, so you can correct anything that is wrong in the report.
From time to time, lenders may change the way they calculate scores. For example, in times of recession, when more people default on their loans, they may reduce even further the scores of people who have negative entries and past defaults.
Your credit score can also affect your existing interest rate on a personal loan. Lenders regularly review their existing customers and apply what's known as a ‘rate-for-risk pricing policy’. This means if a lender considers a group of people is now at a higher risk than before, it might consider putting up the interest rate for all the people in that group.
If you fall into that group, you could find your interest rate going up, even though you've been a good customer and paid on time. This is why keeping a good credit score at all times is essential, even if you don't want to borrow more money.
And when you do compare credit cards, your credit score will affect whether you get the advertised rate or are given an alternative offer. Those with the strongest credit scores will be accepted, but those with lower scores might be offered a higher interest rate, for example.
What can affect your credit score?
There are a number of things that can affect your credit score. These include:
- Your payment history – do you pay on time; if you were late, how late? Have any of your accounts gone to debt-collection companies? Do you have any bankruptcies or County Court Judgments against you? A bad repayment history will make new lenders more nervous about being paid back.
- How much you owe and how much of your available credit you are using – a lender will look at how much you owe overall and how much have you paid back, as well as how close to your credit limits you are.
A lender will consider the affordability of what you are asking for, given your earnings and the amount you owe. It may look to see if you have different kinds of credit - like a mortgage, car loan and credit card - to see if you are paying them all back responsibly. It might also consider accounts that you have but never use.
- Length of credit history – how long have you been using credit, and how responsible have you been over that period? A longer history is likely to be helpful, but if you only have a short history you may be fine if you've made payments on time and don't want to borrow too much.
- How much new credit you have - if you have made a lot of recent applications for credit, you are likely to be a greater credit risk. People tend to ask for more credit when they are struggling financially.
Every time you make an application for credit this will be recorded on your credit record and this can have a negative impact on your score.
What should you do if your credit score is low?
If your credit score is low, try not to panic. There are a number of steps you can take to improve it – find out about them here.