Credit Scores: Everything You Need to Know

Learn about credit scores and what can impact them
 
R.Dodger - November 4, 2009
   
Have you noticed that you’ve been pre-qualified for a credit card, car loan, or mortgage without any input from you? Have you been able to get approved online for a personal loan within minutes?

This is all possible through the use of credit scores.

Financial institutions, banks, landlords, and even employers rely on credit scores to make financial, tenancy, and even employment decisions every day.

We started using credit scores in the 1980s as computers became cheaper and more common place in the business environment. Previously, lending decisions were made manually using human judgment, which resulted in unpredictable and unreliable outcomes. It was also a slow and tedious process.

Earlier there was growing concern in Congress regarding discrimination in housing that resulted in legislation to remove the human factor when reviewing credit applications. Beginning in 1971 with FCRA, and again in 1977 with FDCPA, legislation forced the Credit Rating Agencies (CRAs) to improve their rating procedures.

The first standard was the point system, which used a weighted list of numerous items on the credit report. This removed much of the ambiguity and bias associated with credit ratings. Shortly after, the point system was replaced by the statistical modeling of thousands of report items covering hundreds of variables related to consumer payment histories.

Considered the premier predictor of consumer credit behavior, many financial institutions quickly adopted FICO (the Fair Isaac Company statistical model). FICO quickly became the de facto standard, and was the industry’s answer to Congressional pressure to eliminate discrimination in the rating process.

It also provided clear advantages: a more accurate predictor of credit payment behavior; faster processing of applications; and highly objective results.

How does it work?
Credit scoring relies on Risk Factors. This means that those placed in a high risk category are rated relative to others in the same category. If your credit history is limited, then you will be compared with others in your category (of limited history).

Carrying this further, entries to a credit report are grouped into what are called Score Factors. These are groups that comprise the credit score. Some Score Factors are: number of loans; number of credit card accounts; debt to income ratio; payment history (including late payments, bankruptcies, foreclosures, etc.); employment status. If you have been denied credit, you can request (and should receive) the specific Score Factors that led to the rejection.

Credit scores have a range from 300 - 850. Your credit rating improves as the score increases. The three major credit bureaus are: TransUnion, Equifax, and Experian. Each has its own version of FICO and differences in credit history, resulting in three credit scores. Generally, lending institutions will take the top or bottom two scores when evaluating applications.

Scores above 720 - 750 are considered excellent. Above that it’s a cushion for possible negative entries.
Below is a guideline of credit report scoring…

• 35% from payment history. If you have any collections, charge offs, late payments, short-sales, judgments, bankruptcies, liens, etc., this will negatively impact your score. These negative entries to you credit report generally have a long life (they stay on the report for years).

• 30% is based on how your debt is distributed (called utilization). For example, it is better to have a number of accounts with low balances than just one or two accounts that are near their max limit. An example utilization formula is: Current debt divided by Credit limit. The lower the debt to credit ratio, the better. Try staying below or at 10%. For example, if your credit limit on your card is $16 thousand, and your current outstanding debt on the card is $4 thousand, then your ratio is 25% (4 / 16) which is too high. In this case, either reduce your debt or raise your credit limit.

• 15% from Established History. The older your active accounts, the better. When you’re first establishing credit, it would help if you could be added on another person’s established account as an Authorized User (generally done within the family, such as parents). Established accounts are those that have been active for awhile. Becoming an Authorized User on those accounts will boost your score.

• 10% Inquiries. Basically, the more hard inquiries of your credit score or credit report, the lower your credit score becomes. Thus, try to keep the number of hard (authorized) inquiries to a minimum

• 10% Mix of Credit. Having different forms of credit will help your score, such as revolving credit, mortgage, auto, installment loans, etc. Try keeping an equal balance amongst the various forms of credit.

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