Being fully prepared with the best chance to get the best interest rates when applying for a loan is essential and will benefit you in the long run. This article will serve as a guide to understand credit scores, and exactly how they are calculated so that you can better support your credit score growth.
What is a credit score?
Your credit score is a three-digit number that is calculated based on your credit reports. It is an indication of your history with credit and will show lenders how responsible you are with debt. Credit scores can range from 300-579: poor, 580-669: fair, 670-739: good, 740-799: very good and 800-850: excellent. The higher your credit score, the lower risk you are to lenders as opposed to low credit scores with more risk. This then affects the type of deal you are offered on loans and credit in terms of fees and interest rates. Borrowers with a lower credit score have a higher chance of defaulting on their loans due to previous credit interactions, so may receive higher interest rates to offset this risk to lenders.
How is a credit score calculated?
It’s imperative to understand how your credit score is calculated so that you’re able to keep track of your financial decisions. Your credit score is a representation of your information held by credit bureaus and is analyzed by a credit scoring system like the FICO® Score or VantageScore® model. The most common factors taken into consideration for your credit score are:
Your debt payment history
Lenders look at how responsible you are with making your debt repayments on time. One missed payment can negatively impact your score, so be sure to make your payments on time consistently. Set an automatic payment method if necessary.
Amount of credit used or your credit utilisation ratio
Your credit utilization is calculated by dividing the total amount of your credit card balances by the sum of all your card borrowing limits. A ratio of below 30% is preferred, showing that you are not overusing your credit. A higher ratio than 30% will decrease your credit score.
Credit history length
A longer credit history likely results in a higher credit score. Creditors take into account the age of your oldest credit account, your newest account, and the average age of all credit accounts on your name.
Your credit mix
A mix of different types of credit accounts, like instalment loans, mortgages, and credit cards, are good to have as they impact your scores positively. However, avoid opening a lot of new accounts at the same time as this can bring your score down.
What credit score do you need to qualify for a personal loan?
Each lender requires different minimum credit scores, but on average the best credit score to have is between 600 - 700. A higher score means you are less of a risk to lenders, and more likely to qualify. A credit score of over 800 is excellent and will have the best competitive interest rates and allow you the freedom of choosing your loan terms.
A longer credit is preferred for a loan application, a minimum of 2-3 is accepted but longer than this is better. Making your debt repayments on time, on multiple accounts over a long period means that you are responsible for payments.
Your debt-to-income ratio is your debt owed against your monthly income. This shows lenders how much you would be able to repay each month towards your debts. Ensure that your income is stable enough to take on another loan before you apply.
How to get a credit report
Before you apply for a loan, assess your credit and financial situation. Your credit report can help understand what you would need to do and how to increase your credit score. South Africans are entitled to one free credit report from any of these credit bureaus; TransUnion, Compuscan, Experian, and XDS (Xpert Decision Systems).
Visit their websites to access your free credit report and assess how you can improve your status if needed.
How to improve your credit score before applying for a loan
- Pay your accounts on time and in full wherever possible. Avoid paying minimum amounts towards your debts.
- Only use credit where you need to, without reaching your credit limits.
- Keep your credit card debt as low as possible as they have the highest interest rates and will hold you back from keeping your balances low.
- Avoid owing more than 30% of your income on debt.
- Make arrangements with lenders if you find yourself unable to pay back your debts.
Prepare your credit score ahead of time if you plan on taking a personal loan out. Keeping to a payment schedule and not overusing your credit will help you achieve a credit score above 600 to qualify on your application.