How Credit Scoring and Loans Interact

Your credit score is one of the most important factors in getting approved for a loan. How is it calculated, and how does it affect your application?

When you're in the market for a personal loan, one of the biggest factors that will influence the kind of deal you can get is your credit score. Most people have heard of credit scoring, but not all of us really understand what it is and how it interacts with financial products such as loans.

The process of credit scoring is made possible by companies called credit reference agencies, who collect and store information on the financial activities of all of us. Details such as credit applications we've made, credit searches carried out on us, payments we've missed or made late, and debts that we've not paid are all held on what's known as a credit file. Every one of us who's made contact with the financial services industry will have a credit file dedicated to us.

When you apply for a loan, the first thing the lender will do is request a copy of your file from one of the credit reference agencies, so that they will have the bare facts of your financial and credit history available to them to help them come to a decision. It is not however, contrary to popular belief, the credit agencies who decide whether you're a good or bad credit risk, and they have no direct control over your credit score.

This will be determined by a set of credit scoring criteria drawn up by the lender, of which your credit file is only a part. Each kind of entry on your file will be given a 'weight' in the scoring process, along with other information you gave on your application form such as income, residential status, marital status, length of time in employment, and so on. The importance given to the various factors will vary from lender to lender. For example, one company may place great importance on being a homeowner with a high income, and may not to be too concerned over previous late payments or arrears. In contrast, another company may not be concerned about where you live, but will take a dim view of any previous black marks on your file, however inconsequential.

Once all this information has been weighed up, the lender will be left with an overall credit score. If this score is below their minimum threshold for approving a loan, your application will be rejected. If your credit score is excellent, then you will likely be approved at an attractive rate of interest. The majority of people will, naturally, fall somewhere between these two positions, and will be offered a loan at an interest rate that reflects their individual credit score. By law, the interest rate that two thirds or more of applicants can expect to be offered is the one that should be given greatest emphasis and prominence in any advertisements or marketing material.

If you find that your credit score is too low to get a decent loan deal, then you can look into ways of improving your credit rating. This is a whole new subject in itself, but suffice to say that you should be wary of any companies who claim to be able to dramatically improve your credit rating. This is in many cases unrealistic. What you can do though is to get hold of a copy of your credit file yourself, for a minimal fee, and check that all the information on it is correct. By doing this, you'll at least be getting your loan application off to a proper start.

About the author: Michael writes for Loan Vision, a loan comparison and information site covering secured loans, personal loans, and bad credit finance.