Your Credit Score: How it Really Works and Why it is Important

What is a credit score 2We’ve all seen the ads talking about your credit score and offering to give you a free report so you can know where you stand, but what is a credit score?

If you thought that it was all your financial transactions put together to calculate a random number representing your financial health, you’d be wrong. In fact, in the UK, there is no such thing as a universal credit rating.

Your credit score will vary from lender to lender – and even between different types of credit. You could get accepted for a mobile phone account and declined for a bank loan, for example even though your credit history is unchanged between applications.

What Is Credit Score

In short, your credit score is a figure that is meant to show how good a risk you are. The higher your score, the greater your chances of being accepted for a loan – and it may even result in your receiving a better rate than others with a lower score.

How is Your Credit Score Calculated?

What is a credit score The answer isn’t quite as straightforward as you might hope, since each lender has its own criteria for calculating your credit score and their individual methods are a closely guarded secret.

However, as a general guide, you can assume that they’ll have looked at your credit report, which is a basic history of your financial dealings.

They’ll have examined the information you provided on their application form, such as employment history and current salary, and taken into account any past dealings they’ve had with you (assuming you’ve borrowed from them before), to determine your credit score and decide whether they want to lend to you.

If you’ve been declined for a loan, it’s easy to assume that you’ve been blacklisted.

In fact, there isn’t a blacklist per se. It’s just that if you’ve got a history of defaulting, unsurprisingly, lenders may well decide that you’re a poor candidate for further borrowing.

In these days of responsible credit, the onus is on the creditor to assess your situation and decide whether you can afford to repay the amount you want to borrow.

It’s not the end of the world if you’ve been declined for a loan, since there are firms that specialise in dealing with people with poor credit score.

Just bear in mind that they’re likely to charge you a hefty fee for the privilege, so it’s worth checking your credit file for errors first to make sure that you aren’t being unfairly penalised.

How Do You Check Your Credit File?

What is a credit score - check credit recordThere are three main companies in the UK who hold credit reference files on individuals aged 18 or over.

They are Equifax, Experian and Callcredit. Get into the habit of checking your files on an annual basis to make sure that no mistakes have crept in, since those errors can wreck your chances of getting credit.

Different lenders use different agencies, so try and check with all three if you can, or at least Experian or Equifax, the biggest two.

You have a statutory right to check your files for a mere £2, although there are ways to do it for free.

For example, Experian allows you to sign up for a month’s free trial, although you will incur charges if you don’t cancel during that month.

Equifax also offers a free month’s trial, although you can also get monthly Equifax credit reports for free through Clearscore.

If you sign up for the free reports, you’ll receive regular recommendations for credit cards and loans from them. They receive a commission for any you take out – but you’re not obligated to do so to get the reports.

What is a Credit Score Really About?

What is a credit score Your credit score looks at your past financial behaviour to try and predict your future performance. If you don’t have much of a credit history, e.g. because you’re young or you’ve lived overseas, this can be difficult.

A lack of credit history can make it just as difficult to get a high credit score as a bad history.

If you don’t have a credit history, there are ways to build one up in a short space of time, such as registering to vote.

If you aren’t registered, you’re likely to be turned down flat, no matter what you’re applying for, since lenders need to confirm that you are who you say you are and aren’t just a fraudster looking to run off with their money.

Get a credit card and make sure you use it responsibly by always making payments on time. However, you may be surprised to hear that paying your card in full every month isn’t always a good thing.

That’s because credit scoring is just as much about determining how profitable you are to a lender as it is about your level of risk.

Someone who pays their card off in full all the time is far from ideal for credit card companies. They prefer customers who are permanently in debt, never default and meet the minimum repayment.

If you aren’t using your card, pay it off all the time or take advantage of 0% deals to shift your debt, you may find you’re rejected for further cards.

What about Banks?

what is a credit score bankWell, they may look at factors like what products you might consider in the future.

They may tempt you in with a good deal on a current account, but when they calculate your credit score, they’re really looking to see whether you’re likely to take on a much more profitable – for them – mortgage in the future.

If they don’t think they can sell you a mortgage, they might decide that they don’t want your current account business either.

Just How Much Do Lenders Know about my Credit Score Anyway?

When you know what information lenders have access to, it makes it easier to present yourself as the ideal customer.

Obviously, they have the information requested on their own application form, so be as accurate as you can when filling them in.

They are likely to filter the form through fraud prevention services, so if you provide contradictory information on forms, e.g. different job titles or phone numbers, this can be a red flag you might not be told about.

In addition, they look at any past dealings with you. This is why, if you have a limited credit history, your own bank is more likely to lend to you than a different one with a better rate.

Conversely, if you’ve had problems with a lender, they’re less likely to give you a second chance.

Then there’s your credit reference agency files, obtained from either Equifax, Experian or Callcredit. This is why it’s so important to know what’s contained in these files and correct any errors.

Information is collated from four main sources: the electoral roll; court records, including county court judgements (CCJs) and bankruptcies; previous searches carried out by other lenders; and account data from banks, building societies, utility companies, etc.

This will include details of your account behaviour on credit/store cards, loans and payday loans, mortgages, bank accounts, etc. over the last six years, and may also include the amount you repay on loans and whether you’ve taken advantage of any promotional deals.

In addition, there may be information from energy or phone providers, details of any social rent payments and fraud data, either information about fraud you have committed or if someone else has stolen your identity and committed fraud in your name.

What They Don’t Know – Unless You Tell Them

What is a credit score Credit reports are so comprehensive, it’s easy to assume that every facet of your life is contained in them, but although the amount of data included has been growing over recent years, there’s still plenty of information lenders won’t have access to unless they’ve specifically asked for it.

This includes such things as whether you’ve checked your file, council tax arrears, parking or driving fines, your marital status, your race, religion or ethnicity, your income, your savings accounts, your medical history or your criminal record – assuming you have a criminal record, that is!

You Can’t Always Get What You Want

Don’t assume that when you apply for a loan it’s a simple case of you either get it or you don’t. In fact, your credit score might mean that a credit provider will give you credit, but not at the rate you asked for.

For example, loans are advertised with a representative rate, but under the law, only a minimum of 51% of accepted applicants must receive that rate. You can read our handy guide on What is APR, for more information on representative rate.

You might apply for a loan with an advertised rate of 5% (the representative APR), but you might find that you’re accepted with the offer of an interest rate of 35% due to your poor credit score.

Alternatively, you might apply for a credit card offering a 0% introductory rate in an attempt to manage your debts, but you could be offered a shorter 0% period or even a different product altogether.

The reality is that no lender is obligated to give you anything.

Although the Government encourages lenders to offer more credit, the final decision still remains with the individual providers as to whether they view you as a profitable, low risk customer.

Don’t Pay For Your Credit Score – How to Check your Credit Score

What is a credit score If you’ve been paying attention, by now you should understand the difference between your credit score (the figure calculated by individual lenders based on their own secret algorithms) and your credit file (the collation of your financial data that enables lenders to calculate your credit score, in conjunction with other information).

Your credit file matters. Your credit score doesn’t, at least not without context.

Although some credit reference companies will try to sell you a credit score, by itself, the number is meaningless.

It will not tell you whether a specific company will sell you a specific product, whereas your credit file will give you a good indication of how healthy your finances are and how good a candidate credit providers will consider you to be.

Again, this is why you should be keeping an eye on your credit file and correcting any errors or taking steps to improve your credit rating.

This is what will impact your future credit, not some number generated by a company looking to make a quick buck.

Who Cares About Your Credit Score Anyway?

Just because you can’t get a single number that represents how all lenders will view you doesn’t mean it doesn’t matter. It does. A lot.

If you’re planning on taking out a mortgage, if your credit score is poor, you don’t stand a chance. If you know you’re going to be buying a house, plan ahead and start improving your credit file at least a year beforehand.

Credit card providers will use your credit score to decide whether to give you a card, what promotional rate to give you (if any) and what APR to charge after the promotional period ends.

This also extends to loans, where your credit score determines if you can borrow the money you need and how much you’ll need to repay.

If you want a mobile phone contract, you’ll be credit scored. Since the mobile company generally offers subsidised or free handsets (and maybe other goodies too), they view your contract as being effectively the same as a loan, so if you won’t be able to keep up with the payments, you’ll have to resign yourself to pay as you go.

When it comes to renewing your car or home insurance, if you want to pay money, your insurer will, in effect, lend you the full amount upfront so you can repay it over the year, plus interest (which may be as much as 20%APR).

They’ll carry out a credit check to make sure you’ll maintain your payments.

How to Improve Your Credit Score

What is a credit score If you’ve taken the plunge and read your credit report, if you’re shocked at what you’ve seen, don’t panic.

There are ways to improve your rating in a relatively short amount of time.

We’ve already mentioned the importance of being registered to vote, but if you’re ineligible to vote in this country, send the big three credit reference agencies proof of residency, such as a utility bill or driving licence and request that they add a note to confirm that you’re living here.

Never default or miss a payment. Even one missed payment can damage your credit rating for years, the first 12 months feeling the most impact.

Set up direct debits to ensure you’re paying at least the minimum amount per month and top up as necessary. If you really can’t cope with repayments, then talk to your lender.

A change in repayments is infinitely better to defaulting and although it will still have an impact on your credit score, the damage is far less than a county court judgement will be.

If you’re turned down for a loan, this will appear on your credit file and have a negative effect, so use an eligibility calculator, such as those on moneysavingexpert to carry out what’s called a soft search to check the likelihood of your being accepted.

Lenders won’t be able to see these soft searches, but you can potentially avoid the damage of being rejected in an application.

If you have been rejected, have a look at your credit file to see if you can pinpoint why before applying again.

This helps you avoid the spiral of further rejections, dragging your score down even further.

Credit cards can help you (re)build a credit history quickly. Although you might find that you can only get a card with a high interest rate, if you pay it in full every month, this can improve your credit history in relatively short time.

Do not, under any circumstances, use your credit card to withdraw cash, unless you’re overseas and it’s a specialist card specifically for that purpose.

Lenders will view this as poor financial management – and the fees for doing so are disproportionately high.

Your Turn…

Do you know what your credit score is? Have you been able to successfully improve a poor credit rating in the past? We’d love to hear about it – let us know in the comments below.

This post is part of the Debt Management series, you can read all posts in the series here.

(Photo Credit: nenetus@freedigitalphoto.netMarjan Lazarevski, Got Credit)

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14 Comments

  1. This is such a really good breakdown of credit scoring. As someone who has worked in the finance industry for over a decade, I often have people asking me about the subject. Thanks for sharing.

  2. This is really useful information, I have used a couple of credit referencing agencies in the past as we had a concern about my score, and found them to be very useful. I wish that things like this were taught to kids at school, so they have a full understanding of money before they are let loose into the big wide world!

    1. Hi Leah thank you very much for taking the time to share your comments. I completely agree with you. Children should be taught more about money at school as this will help them learn how to manage their money in the future. The good news is that, we can teach our children about money as we learn and develop our financial management skills.

  3. Great informative post.
    I must admit I need to check my score again.
    Great tips on improving your score my husband has manged to improve his score recently. It’s important to know about it and also think children need to learn more about money from a young age.

  4. This was a really useful breakdown. I’ve always been confused about my credit score. I didn’t realise that paying my credit card off in full each month wasn’t helping things!

  5. I know what my credit score is but seem to be able to improve it thanks to Avon who are being idiots and saying I owe them money when I don’t.

  6. This is so useful. I remember being refused a loan because I hadn’t had one before. I was gobsmacked! Now that we have a mortgage, we are offered loans all the time but we don’t take them out as we don’t need them these days!

  7. This is useful for someone who does not understand Credit scores. Mine was so good for years and then i married my husband and although I’ve never missed a payment in my life, my score dropped massively because I was married which kind of sucked and we have been working for years to get it back up!

  8. Everyone needs to know this I wish they would teach this too kids at school as it really is a life skill that should be taught.

  9. Credit scores are so important! I panic about mine all the time lol Our financial adviser told us to sign up for Noddle which is free

  10. It’s so important to be aware of your credit score. I love all your advice, it’s simple to understand. I think too many people are over whelmed by financial matters so blogs like this really help

  11. This is a very in depth yet easy to understand explanation. Thank you for putting it together. I’m sure many people will find it useful

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