Credit Score

A Credit Score is something we have been hearing or rather we hear all the time. In the US Banks talk about your credit score when you go to get a loan. Right from getting a loan to getting a job, your credit score is something that is checked. Even in India private banks and lending institutions have started checking the credit history of a customer before entering into a loan agreement with him. So, it is imperative that we learn what a credit score is and how we can build it.

What is a credit score?

A credit score is a number that lenders use to estimate risk. Experience has shown them that borrowers with higher credit scores are less likely to default on a loan. Usually banks and lending institutions would prefer somebody with a good credit score than someone who does not have such a strong credit score.

How are credit scores calculated?

Credit scores are generated by plugging the data from your credit report into software that analyzes it and cranks out a number. The three major credit reporting agencies don't necessarily use the same scoring software, so don't be surprised if you discover that the credit scores they generate for you are different. Generally lesser your outstanding debt and better the pay check you receive every month, it is better for your credit score. For ex: let us say A & B draw a salary of Rs. 50,000/- every month. A has a home loan for which he pays an EMI of Rs. 20,000/- every month whereas B does not have any such loans. So, obviosly the credit score of person A would be better than that of B and he would stand a better chance of striking a better deal or a loan from any bank or financial institutions.

Which parts of a credit history are most important?

There are many aspects of your credit history that affect your credit score.

35% - Your Payment History - Credit cards, Telephone bills and other utility bills
30% - Amounts You Owe - Outstanding credit amounts in loans and credit cards
15% - Length of Your Credit History
10% - Types of Credit Used
10% - New Credit

Why is your credit score important?

The credit score of an individual is an indicator of how worthy he is as a borrower to receive a financial product from a bank. A loan is a commitment on the part of the borrower or the customer to repay the loan. So, a bank would prefer a customer who has a better chance of repaying the loan than someone who has a past of being irregular or delinquent in his payments.

Most customers with decent credit scores manage to get a loan or any other service from a bank but at a price. Let us take the same example as above A & B. The rate of interest at which person B gets any new loan would be lesser than person A. This is because person A has a lesser credit score and hence the bank would want to collect as much money as possible from B before he stops making payments. If A manages to pay off his loan properly, this would eventually improve his credit score.

Credit scoring software only considers items on your credit report. Lenders typically look at other factors that aren't included in the report, such as income, employment history and the type of credit you are seeking.

What's a Good Credit Score?

Credit scores (usually) range from 340 to 850. The higher your score, the less risk a lender believes you will be. As your score climbs, the interest rate you are offered will probably decline.

Borrowers with a credit score over 700 are typically offered more financing options and better interest rates, but don't be discouraged if your scores are lower, because banks service nearly everyone.

It is believed that only around 10% of the population has a credit score of over 800. The bulk of the customers who receive services from banks and financial institutions are in the 550 - 700 score range. Anyone who has a score of over 700 can easily get services from banks without much of a hassle.

The next article would be on how to improve your credit score.

Common Financial Terms - Part V

Broker recommendation

An opinion given by an analyst to his/her clients about whether a given stock is worth buying or not. Wall Street investment firms employ thousands of analysts whose job is to issue reports and broker recommendations on specific stocks. These analysts typically look at the company's fundamentals and then build financial models in order to project future trends, most notably future earnings. They then use these projections as a basis for issuing broker recommendations on whether or not they think the stock should be bought or sold. Each brokerage has its own terminology, which makes it difficult to compare broker recommendations between brokerages, but the most common ratings are (in descending order of quality) strong buy, buy, hold, and sell. also called recommendation.

Reverse split

A stock split which reduces the number of outstanding shares and increases the per-share price proportionately. This is usually an attempt by a company to disguise a falling stock price, since the actual market capitalization of the stock does not change at all. For example, if a company declares a one-for-ten reverese split, then a person who previously held 20 shares valued by the market at $1 each will then have 2 shares worth $10 each. Many stock exchanges in the U.S. do not allow companies with a stock price of less than $1 to remain listed, and many such companies then have to undertake reverse splits if they want to remain listed.

Gold standard

A monetary system that backs its currency with a reserve of gold, and allows currency holders to convert their currency into gold. The U.S. went off the gold standard in 1971.

Vertical spread

An option strategy involving the simultaneous purchase and sale of options of the same class and expiration date but different strike prices. also called price spread.

Permitted currency

A minor foreign currency that is allowed to be converted into a major currency, such the U.S. dollar.

Dollar drain

A situation in which a country's imports from the U.S. exceed their exports to the U.S., which results in a reduction in their dollar reserves. The idea can also be applied to currencies of other countries.

Municipal bond fund

A mutual fund which invests in municipal bonds. These bond funds are popular among investors in high income tax brackets because they are exempt from federal taxes and, in some cases, from state taxes as well. As with U.S. government bond funds, the underlying securities in municipal bond funds are backed by the government and thus are considered to have a high credit rating. However, municipalities have been known to declare bankruptcy on occasion, making these funds more risky than U.S. government bonds. also called muni fund.

Double taxation

Taxation of the same earnings at two levels. One common example is taxation of earnings at the corporate level and then again at the shareholder dividend level. Another example is taxation of foreign investments in the country of origin and then again upon repatriation, although many countries have signed agreements to prevent this latter type of double taxation.

Federal Reserve System

The central banking system of the U.S., comprised of the Federal Reserve Board, the 12 Federal Reserve Banks, and the national and state member banks. Its primary purpose is to regulate the flow of money and credit in the country. The Federal Reserve was established in 1913 to maintain a sound and stable banking system throughout the United States and to promote a strong economy. The Board of Governors is made up of 7 members that are appointed to 14-year terms by the President and approved by the Senate. Almost all U.S. banks are a part of the Federal Reserve System, which requires that those banks maintain a certain percentage of their assets deposited with the regional Federal Reserve Bank. These "reserve requirements" are set by the Board of Governors and by changing the requirements, the Federal Reserve System can greatly impact the amount of money supply in the economy. The Federal Reserve System has several functions. First, it serves as a bank for banks: many transactions between banks are processed through the Federal Reserve System. Financial institutions are also able to borrow money through the Federal Reserve, but only after attempting to find credit elsewhere; the Federal Reserve System provides credit only when it cannot be found in the markets or in cases of emergency. Second, the Federal Reserve System acts as the government's bank. The tax system processes incoming and outgoing payments through a Federal Reserve checking account. The Federal Reserve also buys and sells government securities. The Fed even issues the U.S. currency, although the actual production of the currency is handled elsewhere. Third, the Federal Reserve System acts as a regulatory agency. The Fed polices the banking industry to make sure that things run smoothly and that the rights of consumers are protected.


Interest rate cap

A provision of an adjustable rate mortgage limiting how much interest rates may increase in a single adjustment period.

An options contract which puts an upper limit on a floating exchange rate. The writer of the cap has to pay the holder of the cap the difference between the floating rate and the reference rate when that reference rate is breached. There is a premium to be paid by the buyer of such a contract in order to gain the certainty of a maximum payout.

Financial Terms - Part I
Financial Terms - Part II
Financial Terms - Part III
Financial Terms - Part IV
Financial Terms - Part VI