Education

Introduction to Credit Scores

A credit score is a number, generally between 300-850,
assigned to you to rate how risky a borrower you are
the higher the score, the less risk you pose to creditors.

Your credit score plays a vital role when lenders decide
whether to extend you credit. According to Fair Isaac
Company, over 75 percent of mortgage lenders and over 90 percent of credit card lenders use credit scores when making their lending decisions. A low credit score may result in a denial of credit. Furthermore, lenders will charge higher interest rates on loans to individuals with lower scores. This practice is known as risk-based pricing.

In addition, your credit score is used in decisions beyond lending matters. Employers, utility service providers, among many others, use credit scores to evaluate whether to offer their services to individuals, and uses for the credit score continue to expand. Perhaps the most troublesome recent use of the credit score is by insurance companies to establish rates. In short, the decisions relating to whether you receive even the most basic services comes down to this single number.

Equifax, Experian, and Trans Union dominate the credit reporting business. These three agencies use three different models for credit scoring. Fair, Isaac and Company develops scoring models for Equifax and Trans Union, which is why they are also called FICO scores. Experian will start to use models developed by Scorex, with whom they merged.

Credit scoring models are developed by analyzing statistics and picking out characteristics that are believed to relate to creditworthiness. Credit Reporting Agencies (CRA) use different scoring models for different purposes. Auto financing, for example, could employ a different model than installment loans. Credit scoring models have long been shrouded in secrecy. Individuals and consumer advocates have found it difficult to ascertain information regarding what factors the models consider, and to what degree. It was only until recently that individuals could even obtain their own score. There is still no general federal legal obligation on CRAs to provide credit scores to individuals. However, some credit services companies now sell the credit score and advice for improving it for a fee.

The Equal Credit Opportunity Act forbids creditors from considering race, sex, marital status, national origin, and religion. Lenders and other institutions argue that credit-scoring systems provide a consistent, mathematical system to evaluate individuals. Institutions argue that a credit score is superior to the previous method of evaluation by a loan officer because the loan officer was given too much discretion, which gave rise to problems such as bias. Others argue that the disparate loan denial ratio has not changed since the implementation of the credit score, and the outright discrimination of the past was simply replaced with a more subtle form of discrimination that is built into the credit scoring calculations through the programmers’ judgment calls regarding which factors to consider, and the amount of weight assigned to these factors.

Expanding the Use of Credit Scores

More services use credit scoring to evaluate their
customers. As such, individuals with low credit scores
are finding it more difficult to obtain good and services.

Perhaps the most controversial new users of credit
scores are insurance companies. Insurance companies
are using credit scores to assess risk levels and loss
ratios. Insurers believe that customers with low credit
scores are more likely to make insurance claims.
Despite the lack of a causal link between a credit score
and insurance risk, insurance companies nevertheless
can raise an individual’s rates or even deny coverage
based this number. For example, whether or not you
have an outstanding loan can cause your auto insurance
premiums to increase, even if you have a perfect driving
record. Critics charge that this use of a credit score is
completely arbitrary and it is an unfair business practice. Certain states have attempted to take action against insurance companies using credit scores. In California, lawmakers defeated a bill that would have banned insurance companies from using credit scores to set rates and deny insurance. An Alabama regulation in its final stages that would prohibit insurers from considering an individual’s lack of credit history.

What Information Does Credit Scoring Models Use

to Calculate a Score?

Credit scoring models compute your score primary from
information contained in your credit report. The models
might also take information from credit applications into
consideration, including your occupation, length of
employment, and whether you own a home.

According to Fair Isaac and Company, your payment
history accounts for approximately 35 percent of your
credit score. Your payment history reflects the various
accounts that you have, including credit cards, mortgage
loans, and retail accounts. Collections, foreclosures,
lawsuits, and other collection items also fall into this
factor.

The amount of money that you owe approximately accounts for 30 percent of your credit score. The manner in which a credit score reflects this amount, however, is complicated. As Fair Isaac explains, “Part of the science of scoring is determining how much is too much for a given credit profile.” The credit score takes into account your last reported balance, whether or not you pay the balance off in full. The score pays particular attention to the amount you owe in revolving credit” such as credit cards. For example, if you have several credit cards with a small balance that you pay off regularly, then this reflects better on your score than if you had the same number credit cards with no balance, because the latter shows a greater likelihood of “maxing out”those cards. In the same vein, if you have too many credit cards it will reflect poorly on your credit report.

Ten percent of your score falls under a category that Fair Isaac categorizes as “new credit.” This category reflects factors such as the number of new credit accounts on your credit report. The more new accounts you have open, the more poorly this reflects on your score. In addition, the number credit checks that are run on you in the past year can actually reduce your score. This assumption is that, if you are searching for more credit, then you are a greater credit risk. Fifteen percent of your credit score measures the length of your credit history under Fair Issac’s system. Finally, approximately 10 percent of your credit score evaluates the type of credit you have and whether it is a “healthy mix.”

These factors are just a few among many, and your credit score is determined by a complex formula that takes into account over 100 different factors.

While different lenders may evaluate scores differently, generally, a score above 680 is considered to be prime. Individuals with scores between 680-575 are likely to receive subprime loans, and individuals with scores below 540 will generally be denied credit altogether. If the individual is listed as having filed for bankruptcy, it results in a 160-220 point deduction on their credit score. A bankruptcy will remain on a credit score for 7-10 years. If a delinquent account is added to the individuals credit file, 70-120 points are subtracted.