Understanding your credit score and its effect on your borrowing power

A credit score is incredibly important when applying for a loan. It has a big say in whether you’ll be approved and how much you’ll be approved for. Find out what a credit score is, how it affects your borrowing power, and how to improve it.

What is a credit score?

A credit score, or credit rating, is a number used to assess how trustworthy you are as a borrower.

Lenders use this score as part of their assessment to determine:

• If you’ll be approved for a loan

• How much money they’ll lend you

• If you can afford the loan repayments

Your credit score is calculated by your credit behaviour. If you consistently meet repayments, don’t have many lines of credit and don’t borrow beyond your means, you’re likely to have a good score. Having lots of overpaid debts, rejected credit applications or declaring bankruptcy will all have a negative effect on your score.

Depending on which credit reporting agency you get your report from, your credit score will range somewhere from 0-1,200. You’ll then slot into five bands depending on your score, and again the reporting agency, which are:

• Excellent: The top 20% of borrowers, this group is seen as highly unlikely to have an event in the next 12 months which would prevent them from making repayments.

• Very good/great: This group is seen as unlikely to find difficulty making repayments.

• Good: Missed repayments are less likely to occur.

• Average/fair: It’s likely an event could occur which would cause missed repayments.

• Below average/weak: The bottom 20% of borrowers, it’s seen as likely an event like bankruptcy or defaulting could occur in the next 12 months, causing missed payments.

Why does it affect your borrowing power?

If you have an ‘excellent’ credit score, a lender is more likely to approve you for a loan, give you a lower interest rate, and have more favourable lending conditions. This is because if you have a good credit score, you’re unlikely to have an adverse event which will prevent you from making repayments. As a result, you’re likely to be approved for a larger amount as you’re considered a trustworthy borrower.

In contrast, people with a ‘below average/weak’ score aren’t likely to be approved for much money, if it all. It’s not in the lender’s best interests to lend money in this case, as this group is unlikely to see the loan through to its end, so the lender won’t make any money.

Do pre-approvals affect your credit score?

In short, yes, pre-approvals can affect your credit score. There are two types of credit enquiries: hard and soft. A home loan pre-approval falls under a hard credit enquiry, which means its recorded on your credit file and affects your credit score. Other examples of hard credit enquiries include loan applications and credit card applications. Soft credit enquiries are credit checks you, an employer or an insurance company make and aren’t listed on your credit file, so won't affect your credit score.

One home loan pre-approval is unlikely to affect your credit score, and may even improve it. The problem arises when you apply for pre-approval with multiple lenders in a short amount of time. It’s recommended you shop around for the best loan, but this isn’t the case with pre-approval. Doing this indicates to a lender you’ve been rejected by other lenders and are trying to find one who will lend to you. This isn’t a good look and lenders may assess you as a risky borrower and won’t lend to you.

How to improve your credit score if you don’t qualify for the amount you want

If you have a poor credit score and a lender won’t approve you for the amount you’re after, don’t fear! There are a number of ways you can improve your credit score which include:

• Make credit card repayments on time, consistently

• Pay all bills on time, consistently

• Make any other loan repayments you might have, consistently

• Lower your credit card limit or cancel your card entirely

• Don’t max out credit cards

• Don’t use payday loans

• Don’t apply for too many loans or cards

• Try and consolidate debts

The recent introduction of comprehensive credit reporting, which notes positive credit behaviour and not just negative, has made improving your credit score far easier. 

Want to find out your credit score? You can visit Credit Savvy to get your credit score for free, learn how to protect, improve and use your score to get better deals.

Alternatively, use the link below to see if you qualify for a home loan with loans.com.au.

Get pre-approved