Have you been pre-qualified for a credit card, mortgage, or car loan without submitting an application? Have you been approved online for a loan within minutes?
This is all made possible by using credit scores.
Lending institutions, banks, landlords, and even potential employers employ credit scores to make credit, tenancy, and even employment decisions each and every day.
We began using credit scores in the 80s as computers became much cheaper and more common place. Previous to that, lending decisions were arbitrarily made using human judgment. This led to unpredictable and unreliable outcomes, and was a slow and tedious process.
Prior to this there was growing concern in Congress with regard to discrimination in housing. This led to legislation to remove the human factor when analyzing credit applications. Beginning with FCRA in 71, and again with FDCPA in 77, legislation forced the Credit Rating Agencies (CRAs) to modify their rating procedures.
The point system was the first standard rating system, employing a weighted list of credit report items. While this did remove much of the bias and ambiguity associated with credit ratings, it was shortly replaced by the statistical model which factored in thousands of report items over hundreds of variables associated with consumer payment histories.
FICO (Fair Isaac Company) was one of the first models developed, and soon became the recognized predictor of consumer credit behavior. Most lending institutions adopted FICO as the de facto standard as the answer to Congressional pressure to address discrimination in the rating system.
Statistical modeling also provided clear advantages as well: faster processing, highly predictive; and completely objective.
How does it work?
The basis for credit scoring is Risk Factors. Risk Factors group individuals into risk categories, and ratings are calculated based on relative standing within the group assigned. For example, if someone is placed into the high risk group, that person is rated relative to all other members within the high risk group.
With regard to the credit report, entries to the report are also grouped in Score Factors. Score Factors are the basis for the final credit score. Some items that comprise Score Factors are: number of credit cards; number of loans outstanding; payment history (i.e., bankruptcies, foreclosures, late payments, etc.), debt to income ratio, employment status, and so on. Incidentally, if you are ever denied credit, you have the right to request a copy of the Risk Factors that resulted in the decline.
Credit scores range from 300-850. A higher scored reflects a higher credit rating. Each of the credit reporting agencies (CRAs) provide a credit score: Experian; TransUnion; Equifax. These scores differ reflecting slightly different models and the differences in credit histories recorded. As a result, lending institutions will collect all three scores when processing loan applications.
Any score higher than 720-750 is considered outstanding, and anything above will provide a cushion for an negative entries. The following is a guideline for understanding credit report scoring:
35% from payment history. Your payment history includes collections, late payments, charge offs, judgments, liens, bankruptcies, short-sales, etc.. These items will affect your score negatively, and many will stay on the report for years.
30% reflects your debt distribution (called utilization). Basically, it is best that a number of accounts have low balances than one or two accounts at or near their max limit. Here's a simple utilization formula: Debt / Credit. The debt to credit ratio should be at or below 10%. As an example, if you have credit card debt of $10 thousand, and your credit limit is $30 thousand, then your ratio is 33% (10 / 30). This is higher than 10%, so you will need to either reduce your debt (payoff the balances) or increase your credit limits.
15% from Established History. The older your accounts are, the better. When a person is first establishing credit, it would clearly help that person to be added to another person's established account as an Authorized User (usually a family member, such as parents). Established accounts, by definition, have been active (established) for awhile. Being listed as an Authorized User on established accounts will improve a person's score.
10% Inquiries. Hard (authorized) inquiries of your credit score and report have a slight negative impact on your credit score, but they add up. The more authorized inquiries, the lower your credit score. Therefore, it is best to keep the number of hard inquiries to a minimum (that is, don't apply to several banks for a loan at the same time).
10% Mix of Credit. Your score improves when you have various types of loans or debts. This could include revolving credit, auto loan, mortgage loan, installment loans, and so on. Where you can, try to have the balances about the same.
The author has an MBA in Finance and extensive experience with financial institutions. You can also check out his latest website on Free Credit Check | Free Credit Checks which provides sources for credit reporting and credit scores, or Payday Loans No Credit Check for locating loans without a credit score requirement.
Hi Ruth. Welcome to Searchwarp. Thank you for writing and sharing this article. I enjoyed reading it and learned from it. Best regards to you and yours, ~Nenita~
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