How does credit scoring work?

How does credit scoring work?

9 October 2019 Concept Car

We all know what a credit score is. Even if you don’t have all the details, at least you’ll have have a rough idea of it. Many are even obsessed by it, constantly trying to improve their current rating. But desperately few of us know how credit scoring really works.

And that’s a shame.

Because understanding at least the basics can help you with loan applications, debt issues and your finances in general. It can be a true gamechanger and prove to be invaluable for finding a great car finance deal, for example.

In this special, we’ll devote some time to explaining the mechanism behind credit scoring. As you’ll quickly discover, many details will forever remain murky. But don’t worry: This definitely isn’t rocket science, either.

What do you need your credit score for?

That’s a sensible question, because so many people get the answer wrong. Some, for example, believe that you can not get any kind of loan without an amazing credit score. Others are of the opinion that an insolvency will ruin your credit score for life.

In reality, not all lenders will necessarily make your credit score their priority. True, most will want to look at it. But in the end, they may use other factors to decide whether or not to extend credit to you.

Also, not all loans are created equal. When you’re applying for a payday loan (which you may want to avoid, just as an aside), it is highly unlikely that the company will want to see your credit score. The same will often apply to smaller purchases, where the risk of you defaulting is not particularly high.

You will need your credit score whenever you’re applying for a bigger loan. Sometimes, that’s going to be a new bike. Sometimes, it will be for financing your new car. Or perhaps you’re planning to buy a house.

In all of these cases, the credit score will be part of the deliberations.

Why does it matter what your credit score is?

To lenders, the credit score is an indication of your creditworthiness. The more faithfully you’ve paid back your debt in the past, the better your score. A good credit score, to them, is an indication that you’ll remain faithful in the future. Vice versa, bad financial decisions and failure to pay back your debt in full or in time, will be taken as a bad omen.

Some lenders can be brutally unforgiving. They will reject any application with a below average credit score. Others will be okay with a weak credit score, but will compensate for the increased risk by slapping a risk premium on top of the interest rate. This simply means that your loan is going to get more expensive if your credit score is lower than the lender would like it to be.

So, if you’re asking why your credit score matters, the answer is this: Because the nature of your credit score in- or decreases your chances of success in negotiating a loan or makes it more expensive.

Or, to give a different spin to that statement: By improving your credit score, you can get a better deal.

Who determines your credit score?

There are many different credit scoring agencies in the UK. But only three of them truly matter. These are:

  • Equifax
  • Experian and
  • Callcredit

We’ve written a little bit more about these credit rating agencies in an older blog post. https For now, what you need to understand is simply that each of these agencies uses a slightly different method of calculating the score.

This seemingly trivial statement has some deeper implications. Just think about it:

There is no such thing as ‘your credit score’.

In reality, there are at least three, possibly a lot more of them. And unfortunately, if you’re applying for a loan, you can never be quite sure, which of these your potential lender will use.

But wait … what about the FICO score?

With Brexit and all, you may long have suspected that the UK is a bit different from the rest of the world. Well, when it comes to credit scoring, at least, your suspicions are entirely true.

In most countries, the so-called FICO score is a vital part of determining your creditworthiness. These countries still have credit rating agencies. But their scores tend to be a lot closer together, because all of them are working with the same or very similar data.

FICO is actually an abbreviation and stands for Fair Isaac Company. This company has been in business since 1989, providing predictive analytics. That’s just a fancy way of saying they will try to predict what your behaviour will be in the future based on how it was in the past.

FICO is not the only predictive analytics company out there. But its models have proven to be extremely accurate. This is why all the major agencies in the USA are working with them and why most agencies in the Western world do, too.

In the UK things don’t work that way, however. Here, each of the three rating agencies uses its own algorithms and analytics. Consequently, their scores can be strikingly different.

What does this mean for you?

If you’re applying for a loan, you will want to know not just one credit score from a single credit rating agency. Ideally, you’ll want to know the scores of all the major ones. After all, if your ratings are great with Equifax and Callcredit, this won’t help you if your Experian score is abysmal and this happens to be what the lender uses.

So, your first step should always consist in getting the necessary information. Thankfully, you are entitled to a free credit report from each credit agency once a year. This means you can easily assess your current ratings with all of them.

Importantly, these soft checks will not influence your credit score. Note, however, that a hard check – i.e. when you actually apply for a loan for real and the lender checks it – will leave a trace on your report.

If one of your scores seems to be inexplicably worse than the others, you may want to verify if it is truly in order. Mistakes on credit reports are not as rare as you might think.

If more than one of the credit scores is below par, it is time for a little optimisation. We’ll get to how that works in a bit.

How do credit agencies calculate your credit score?

To be able to improve your credit score, you will need to know how credit scoring works in practise.

Essentially, your credit score condenses a large part of your finance history into a single number.

To do this, credit rating companies are looking at various aspects of your past financial behaviour:

  • Whether you have ever paid back a loan – or parts of a loan – too late.
  • Whether one of your lenders has ever had to contact a debt collection agency.
  • If you’ve ever had (or continue to have) unpaid credit card debt.
  • What your debt utilisation ratio is.
  • If there has ever been a court order against you forcing you to pay back money.

Once the agencies have entered these numbers into their system, they are then weighted. Weighting describes how important they think each of these components is in terms of predicting your creditworthiness.

Then, they run the data through their algorithm. The result is your credit score.

What credit agencies can see

Some of the things credit agencies can see include:

  • Utility bills: This is a bit of a new one, but it makes sense and can actually benefit you. Utility bills are usually not very high and very few people want to run the risk of getting cut off from their water and electricity. So if you continually fail to pay them, this can be an indication of serious financial issues. If you want to improve your credit score quickly, make sure to pay all your utility bills promptly and in time.
  • The time frame of your loan applications. The more you space your applications out, the better. If, on the other hand, you apply with many different lenders within a short time span, this can be taken as a sign that you’re in financial trouble.
  • Your credit utilisation ratio: This indicates how much of your potential debt you’re using up. If you have a credit card which allows you to go £1000 into the red each month and you use that amount up entirely, your credit utilisation ratio is 100%. If you only use £200, it’s 20%. To an outside observer, a very high ratio obviously suggests you depend on debt to get by.

Can credit rating agencies see everything?

No, they can’t

What credit rating agencies can not see includes your income, the soft applications you’ve made to find out your current score as well as any ‘slip-ups you’ve made more than six years ago. Importantly, overdrafts are not part of the report and will not factor into the credit scoring.

Of course, if you fail to pay them, eventually they will take action. Once the debt has been forwarded to a collection agency, your credit score will take a hit.

How can you improve your credit score?

So, in a nutshell, this is how credit scoring works: Agencies are taking information on how you behaved with regards to debt in the past. They ten use that information to estimate whether or not you can be trusted to pay back your debt in the future.

Credit scores differ depending on which parts of the equation credit rating agencies consider to be most important. The credit score can be regarded as a rating of creditworthiness and obviously, definitions of creditworthiness will differ.

Nonetheless, there are a few things you can and should do if you want to improve your credit score.

We’ve written extensively about this on the blog. (see our guide to car finance for poor credit history, for example)

Here’s a summary of the most important points:

  • Limit the amount of hard credit applications: The more you’re applying, the more desperate you’ll look.
  • Close unused accounts: Bizarrely, unused credit potential looks suspicious to lenders.  Therefore, only keep accounts you actually use – and close the others.
  • Make sure to pay back your bills in time. Sometimes, you may not be in a position to do so. Sometimes, the only thing it takes is setting up a standing order.
  • Check your accounts regularly to spot fraudulent activity as early as possible.
  • Register to vote: This just makes sure that your current address information is always up to date. This won’t improve your score, but it can avoid unnecessary suspicions.
  • Limit your credit card borrowing to 25% of your maximum.

These are just a few of the things you can do. Ultimately, credit scoring, however, is not the only thing you can do to improve your chances of a loan. At CCC, we always try to keep an open eye and an understanding ear for your issues. We know that your credit score may not be telling the full story.

Get in touch with us now to find out how we can help you. You may think there’s no hope. But there always is.

9 October 2019 Concept Car