One of the largest credit bureaus in the United States has recently released a report that shows how the credit scores in America have been trending during the second quarter of 2019. One of the most interesting points is that during the last seven years, the average FICO credit score nationwide has increased from 693 in 2012 to 703 by Q2, 2019.
Younger individuals between the ages of 20 and 49 have lower-than-average scores. Around 12% of the U.S. population has a FICO credit score below 550, which may limit their capacity to borrow money and affect the costs associated with doing so.
This guide aims to describe some of the most important details of how credit scores are calculated and how they can affect your borrowing capacity.
What’s a Credit Score and How is it Calculated?
A credit score rates a borrower’s creditworthiness by analyzing several aspects of their past credit experience. In the United States, the most popular credit score is the FICO score, a metric created by the Fair Isaac Corporation. This model determines a borrower’s credit standing by evaluating different variables that are assigned a weight and scored with a number that ranges from 300–850.
Credit bureaus are the institutions in charge of collecting, organizing, and reporting the information associated with the financial transactions made by borrowers. The three largest ones in the U.S., which process the information of over 200 million Americans, are Equifax, TransUnion, and Experian.
There are five main elements that impact a borrower’s credit score. These are:
A borrower’s payment history consists of their past experience with credit accounts. This record provides useful insights into the borrower’s history of fulfilling their financial commitments. Any late payments, or payments that have been sent to a legal collection procedure, will negatively impact their credit score. The payment history of a borrower is the item with the largest weight (35%) in the FICO credit scoring model.
The amount owed variable refers not only to the total balance of a borrower’s current credit accounts but also those accounts’ credit utilization ratio, which is the percentage of the total credit limit a borrower has currently used. This factor accounts for 30% of the borrower’s credit score, and it is negatively impacted by an excessive credit utilization ratio (usually if it is higher than 70%) and by large outstanding balances.
Length of Credit History
The length of a borrower’s credit history is the analysis of how old their credit accounts are, on average. This item has a 15% impact on the overall credit score and is positively affected if the borrower has been holding credit accounts in good standing for a long period of time, especially longer than five years.
A borrower’s credit mix is the combination of different types of credit accounts. This particular scoring variable has a weight of 10% on the overall calculation, and it’s positively impacted by having a credit portfolio consisting of different kinds of loans, including auto loans, installment loans, and revolving credit accounts, such as credit cards.
The new credit variable tracks the borrower’s intention of applying for new credit accounts. The accumulation of credit inquiries, which result from loan applications, may negatively impact this aspect of the score, which has a weight of 10% on the overall calculation.
When combined, these five items calculate a borrower’s overall credit score, and lenders use this score to determine whether they qualify for loans.
Credit bureaus are the institutions in charge of collecting, organizing, and reporting the information associated with the financial transactions made by borrowers.
How Are Credit Scores Used to Determine a Borrower’s Creditworthiness?
Lenders utilize credit scores to understand a borrower’s credit situation. These scores provide a quick look into the borrower’s potential creditworthiness, even though they don’t necessarily tell the entire story.
Most lenders and creditors require a minimum credit score for them to consider extending a new credit line, or to increase the limit of an existing one, and FICO® scores are commonly categorized as follows:
- 550 or lower – These scores indicate a “poor” credit situation, and candidates with such scores may not be considered eligible by traditional lenders.
- 580 to 669 – This is seen as a “fair” credit situation and might be affected by some late payments or an insufficient credit experience.
- 670 to 739 – This is a “good” credit situation that is usually backed by good credit utilization ratios, a decent credit history, and a good number of credit accounts in perfect standing.
- 740 – 799 – This credit situation is seen as “very good,” and individuals with such credit scores usually accumulate positive aspects that impact each of the variables mentioned above.
- 800+ – Only 20% of Americans have an “exceptional” credit score, which indicates that they have a near-perfect credit history. All their accounts are in perfect standing, and they have a long record of great credit experiences.
Most traditional lenders tend to provide loans to borrowers with credit scores higher than 670, as these candidates are the ones who have the highest probability of fulfilling their payments on time. Nevertheless, some lenders are willing to extend loans to individuals with scores lower than 670. These alternatives are commonly known as bad credit loans.
How Will a Bad Credit Score Affect My Borrowing Capacity?
If you have a FICO score of 669 or lower, your access to traditional credit lines may be limited. Most traditional lenders won’t feel comfortable extending loans to individuals with bad scores because of the risk of late payments. And if you do get a loan in such a situation, the conditions may be less favorable.
These are some of the ways your borrowing capacity can be affected by low credit scores:
Higher Interest Rates
If you manage to secure a line of credit from a willing traditional lender regardless of your bad credit, it may come at a cost. In some cases, the APRs offered to individuals with lower credit scores can be twice as high as those offered to individuals with a credit score of 670 or higher.
Lower Credit Limits
Since lenders see individuals with bad credit scores as risky, they will usually abstain from offering borrowers large credit limits. This means that a borrower with a low credit score may not receive a loan of the desired amount, if they are approved for a credit card or a consumer credit line.
The Vicious Cycle of Accumulated Credit Inquiries
If a borrower repeatedly applies for credit at many different places, this will create several credit inquiries, which will affect the “new credit” variable of the FICO score. If this cycle continues, it will negatively impact their score further and reduce their chances of being approved for credit.
Shorter Credit Terms
While most credit lines usually offer 36 to 60 months to repay the loan in full, individuals with bad credit scores may find it difficult to get approved for those credit terms. In turn, they may be offered shorter credit terms that could range from 6–24 months. This usually creates a large debt burden for borrowers as the installments are much higher.
How Credit Score Can Affect Other Aspects of Life
Bad credit scores can also affect employment opportunities since many employers see credit scores as an indication of how responsible a person is. A poor credit score can also create difficulties when renting a house or an apartment, increase insurance premiums, and limit access to financing opportunities.
How Can I Increase My Credit Scores?
There are no shortcuts to improving your credit score. The best way to go about it is to maintain healthy financial habits that allow you to build an outstanding credit profile over the long term, including:
- Paying your bills on time
- Using your existing credit lines only if you need to
- Maintaining a credit utilization ratio of 30–40%
- Avoid applying for a large number of credit lines in a short period of time
- Avoid closing credit accounts, especially older ones in good standing
On the other hand, some short-term remedies will increase your scores:
- Check your credit report to see if it has any mistakes. You can dispute these items formally by asking your credit bureaus to eliminate them.
- If you have been a victim of identity theft, you can report this situation and apply for a temporary freeze of your credit report to make sure none of the unauthorized uses of your credit accounts affect your scores.
- If you have a high credit utilization ratio, consider paying off a significant portion of your debt to reduce the ratio.
- You can incorporate non-traditional credit accounts in good standing by asking credit bureaus to start reporting them.
How Can I Get Approved for a Personal Loan if I Have a Bad Credit Score?
Even though a bad credit score can affect your borrowing capacity, that doesn’t mean you are out of alternatives. Some lenders will be willing to help you in securing a personal loan regardless of your credit situation.
CreditNinja offers different types of unsecured personal loans, including installment loans, debt consolidation loans, and the most important in this context, bad credit loans.
Our 100% online application process removes the need to visit a local branch of your financial institution. Our approval process is one of the fastest in the industry, and we can analyze your situation and provide you with a decision in less than 24 hours.
We offer highly competitive interest rates if you are currently struggling to secure a loan from a traditional lender.