How do credit scores work?

Borrowing money to buy things like houses and cars means you are taking on significant debt to acquire items for your life.

For the initiated, when you take a loan out for an asset, the lender adds interest to the loan which is an amount above the amount you borrowed as a fee for lending the money.

It’s like borrowing a car with half a tank of fuel, when you return it, you will fill the tank up.

Lenders of money such as banks, building societies, credit unions or non-traditional lenders take on risk to extend the loan to you.  The risks could include:

  • You may pay the loan back late
  • You may default on the repayments (not pay at all)
  • Your circumstances may change
  • You may lose your job or ability to pay
  • The market conditions may change

How are interest rates determined?

Without getting into too technical an explanation, the ‘cash rate’ is set by the Reserve Bank of Australia.  They meet each month and their role is to assist the overall economy to provide the growth needed to make everyday Australians lives better.

The Reserve Bank doesn’t lend money to you and me, nor does it have branches or ATMs, but the Reserve Bank looks at what is happening in the economy and adjusts ‘monetary policy’ in accordance with those things.

For example, if inflation is too high (prices are going up too fast or not at pace with wages) the Reserve Bank will adjust up the Cash Rate (% it lends money to banks) to slow our spending. (we spend more on mortgage repayments)

Alternatively, if inflation is too low it usually means there is not enough spending going on, so interest rates are lowered in order to stimulate spending in the general economy

There are many factors that determine the Cash Rate

  • Unemployment rate
  • Inflation
  • Wage growth
  • The Australian dollar (value against other currencies around the world)
  • Australian household debt
  • The Consumer Confidence Index

The RBA meets each month to look at a target of inflation of around 2-3%.  They will look at everything from what a litre of milk costs to the price of petrol to see what is happening in the economy broadly.  It then sets that months monetary policy accordingly (as talked about above)

In the 1980’s, Australia’s banking industry was deregulated meaning the government has less control and the market began to manage itself.  In theory, this creates competition and drives up the quality of service delivered as well as innovation. The RBA was no longer government-controlled and acts independently of the Government.

What has this got to do with credit scores?

Now we know how interest rates are set, we can start to understand how those rates are then passed onto to us the consumer.

We’ve already talked about risk.  This is a big factor.

Think about it this way.  If you had $100 to lend out and you had 3 applicants.


Applicant 1: 

Has been in a job for 3 years full-time.  Has a mortgage they are up-to-date on payments and never missed a payment.  They have a car loan also up-to-date with excellent conduct on the loan.  They save every pay and don’t spend more than they earn.  They have an emergency credit card with a $1,000 limit.

Applicant 2:

Has been in a job for 1 year and is a renter with no assets, but some savings.  They have a car loan that they have been late on a couple of times over the past few years.  Has a credit card that has a $5,000 limit but a balance of $3,000.  They got a  payday loan 3 years ago due to a problem with their pay/bank account.

Applicant 3:

Has been in their job for 6 months and lives in a share house.  They have multiple loans with a few lenders.  They have applied for a car loan 3 times in the past 6 months and been knocked back. They had a car loan 4 years ago that they defaulted payment on, but caught up the payments before the car was repossessed.  They are constantly late with payments on their existing credit commitments.

Which applicant would you be most comfortable lending your $100 to?

Most people would rank them in the order in which they have been put above. Some would not lend to Applicant 3 at all because there is a history and risk of not being paid back. 

Second consideration – what interest rate would you offer to each of the applicants if you were going to lend to them?  

  •  Would you expect a higher payback from the higher risk applicant?
  • Who would you be competing against for Applicant 1?  What if they offered a lower rate than you?
  • What would be the easiest way to see each applicants risk profile to determine the rate?

Credit Scores

Without every bank knowing each person’s personal circumstance, we have what is known as credit scores in Australia.  This score is based on personal and financial information about you that is kept in your credit report.  (this is freely available to you).

How your score is calculated

As mentioned, what is in your credit report determines your credit score calculation.

  • How much money you have borrowed
  • The number of credit applications you have made
  • Whether you pay on time (or at all)

The score is a scale between zero and either 1,000 or 1,200.  The higher the score, the more ‘credit worthy’ you are seen to be.

The actual score then helps the lender work out how risky it is for them to lend you money if they decide to at all, and what interest rate would be offered based on the five-point scale (excellent, very good, good, average, and below-average)

A low credit score could actually affect your ability to get a loan at all.

Knowing your credit score can help you get a better deal with finance, especially if it is a high score!

Setting the rate

With the 3 applicants above, most likely Applicant 1 knows their credit score and the lender will provide the funds at a lower rate than Applicant 2 or 3.  This is not discrimination, this is about risk. The lender is within their rights to determine the risk and to offer a product/service accordingly. When I talked about the market regulating itself, this is what we are talking about.  A person with a good credit score isn’t going to just accept a higher rate, they are going to demand the market adjusts to them.

The higher risk applicant due to their conduct on loans, or the way they have handled money, is going to have less choice and most likely pay more.  The market will determine what the higher risk applicant can have, until the day that the high risk becomes a lower risk, this is how the money market works.

Lenders lend based on risk.  After all, it’s their money.  Just like you wouldn’t risk losing your $100 by lending to someone where there was a good chance they wouldn’t pay you back, lenders base their decisions on risk profiles and act accordingly.

See also: Finance Pre-approvals

My credit score is low – how do I fix it?


STOP applying!

One of the most common mistakes we see potential borrowers make is multiple applications.  They will get knocked back with one lender and then go to more lenders.

Each time you make an application, it can drive down your credit score.  If your score is already low, it may come to a point that you are completely undesirable to any lender, no matter the interest rate.  Take a breath and understand that the lending criteria that has been applied to your circumstance is designed to ensure that you aren’t over extending yourself. This could be from the serviceability of the loan through to the loan to value ratio of the item you are wanting.

It’s tough to accept, but now may not be the right time!

Pay on time

If you want to improve your file, pay your bills on time!  If you can’t pay on time due to a particular circumstance, make sure you are ahead of the game and contacting the lender to make an arrangement. This includes phone bills and utility bills as these are the most common items that people default on – affecting the ability to borrow for things that matter like cars and houses.

Stick to your budget

Don’t over borrow!  Know your budget, stick to it.  Yes, it may be nice to have new shiny things, but if you determine a budget that allows you to save for those items – the future will be brighter for your when it comes to borrowing for assets like homes.

Stay away from pay-day lenders

There are SO MANY lenders in the market place that seem to be offering “Cash in a hurry” or “Access your pay before pay day”, with images of broken fridges or scenarios of the unexpected.

Pay day lending can destroy your credit score in a flash.  A main stream lender will see pay-day loans (especially multiple loans) and determine that you do not save for the unexpected, you don’t stick to a budget and you are a high risk.

What about Buy Now – Pay Later

The basic difference between a buy-now-pay-later lender like Afterpay, Zip-Pay etc is simply that you are paying fees instead of interest. It seems great. Get what you want now, pay later!  Laybuy without the agonising wait.

If you miss a payment, you are charged. If you default, you will end up with a negative mark on your credit history. It also won’t show on your credit file that you pay ontime, so it won’t positively affect your credit score.

Some BNPL services also do a credit check meaning you will have an enquiry on your file. (check with the service to see if they do)   As with the above point, stick to a budget, be disciplined with payments and work out what is more important for your future.


Final word


The finance market is a competitive place.  If you have a low credit score, you may think it is unfair.  Circumstances in your life have led you to having this score, but with any rating, you have the ability to fix it.  It takes discipline and determination.  There are many professional financial counselling services that can help you set a budget and even assist you in understanding how you can reach you financial goals.  It will be a journey, but it always starts with a step.


Disclaimer: The thoughts and opinions conveyed on this website are those of the author/s and are of a general nature. Any information provided does not constitute financial or general advice to you from Journey Finance Australia. When considering financial or insurance products, you should seek your own independent advice from a professional.


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