Credit Scores-What They Are-How They Are Determined

Credit Scores

We apply for credit for many reasons — maybe it’s to buy a new car, house, computer, or get a student loan. Did you know, however, that there is a special number that can determine whether you can do these things, or at least how much it will cost you? Your credit score is a three-digit number that can do just that.

How can a single number be meaningful enough to determine whether you can buy a house or car? Your credit report contains a history of how you’ve paid your bills, how much open credit you have, and anything else that would affect your creditworthiness. Your credit score boils down all of that information into a three-digit number.

In this article, we’ll find out how this formerly secret number is used and how it affects how much you pay for credit, insurance and other life necessities.

A credit score is a number that is calculated based on your credit history to give lenders a simpler “lend/don’t lend” answer for people who are applying for credit or loans. This number helps the lender identify the level of risk they may be taking if they lend to someone. While the same end result can come through reviewing the actual credit report (which lenders usually do), the credit score is quicker and less subjective. The system awards points based on information in the credit report, and the resulting score is compared to that of other consumers with similar profiles. With this information, lenders can predict how likely someone is to repay a loan and make payments on time. It’s the credit score that makes it possible to get instant credit at places like electronics stores and department stores.

Although there are several scoring methods, the score most commonly used by lenders is known as a FICO because of its origins with Fair Isaac and Company. Fair Isaac is an independent company that came up with the scoring method and software used by banks and lenders, insurers and other businesses. Each of the three major credit bureaus (Experian, Equifax and TransUnion) worked with Fair Isaac in the early 1980’s to come up with the scoring method.

The three national credit bureaus each have their own version of the FICO score with their own names. Equifax has the Beacon system, TransUnion has the Empirica system, and Experian has the Experian/Fair Isaac system. Each is based on the original Fair Isaac FICO scoring method and produces equivalent numerical results for any given credit report. Some lenders also have their own scoring methods. Other scoring methods may include information such as your income or how long you’ve been at the same job.

Accessing Your Score

Until recently, your credit score was not available to you. Only lenders and other businesses that used the score could access it. Fair Isaac and Company felt that the score would only confuse consumers since there was nothing to tell them what it meant or what the lenders were looking for.

In 2001, however, all of this changed due to pressure from the U.S. Congress, industry, and consumer groups. Now you can get your credit score at a number of Web sites, including the big three credit bureaus, and at Fair Isaac’s Web site. You can also ask your lender for access to your score when you apply for a loan.

Think of your credit score like you would a grade in school. A teacher calculates grades by taking scores from tests, homework, attendance and anything else they want to use, weighting each one according to importance in order to come up with a final single number (or letter) score. Your credit score is calculated in a very similar manner. Instead of using the scores from pop quizzes and reports you wrote, it uses the information in your credit report.

The number can range from 300 to 900. The formula for exactly how the score is calculated is proprietary information and owned by Fair Isaac. Here, however, is an approximate breakdown of how it is determined:

35% of the score is based on your payment history. This makes sense since one of the primary reasons a lender wants to see the score is to find out if (and how timely) you pay your bills. The score is affected by how many bills have been paid late, how many were sent out for collection, any bankruptcies, etc. When these things happened also comes into play. The more recent, the worse it will be for your overall score.

30% of the score is based on outstanding debt. How much do you owe on car or home loans? How many credit cards do you have that are at their credit limits? The more cards you have at their limits, the lower your score will be. The rule of thumb is to keep your card balances at 25% or less of their limits.

15% of the score is based on the length of time you’ve had credit. The longer you’ve had established credit, the better it is for your overall credit score. Why? Because more information about your past payment history gives a more accurate prediction of your future actions. 10% of the score is based on the number of inquiries on your report. If you’ve applied for a lot of credit cards or loans, you will have a lot of inquiries on your credit report. These are bad for your score because they indicate that you may be in some kind of financial trouble or may be taking on a lot of debt (even if you haven’t used the cards or gotten the loans). The more recent these inquiries are the worse for your credit score. FICO scores only count inquiries from the past year. 10% of the score is based on the types of credit you currently have. The number of loans and available credit from credit cards you have makes a difference. There is no magic number or combination of types of accounts that you shouldn’t have. These actually come more into play if there isn’t as much other information on your credit report on which to base the score.

In summary, a credit risk score is a statistical summary of the information contained in an individual’s credit report. The most well known type of credit risk score is the Fair Isaac or FICO score. This score is not just your average ranking device. Sophisticated mathematical processes calculate the score by assigning numerical values to various pieces of information in your credit report.

The score itself is relative. Some lenders will consider a particular score acceptable, and others will not. Lenders will view scores differently, depending on many factors, including the marketing goals and mortgage underwriting guidelines for that lender.

Not all lenders will work with ‘higher risk’ clients.

There is good news though. Your risk score will change over time as your credit history develops. And you can affect that score by improving your performance with credit. Paying regularly and on time is an excellent start.

Note that FICO scores range from 375- 900. The higher the score is, the better the credit rating. Usually any credit score under 620 is considered bad credit. What that means is that you may not qualify for a ‘conforming’ mortgage. But that doesn’t mean that you won’t qualify for a mortgage at all. Other lenders may be willing to consider your business.

Although it may take time, your goal should always be to continuously work towards obtaining a higher credit score.

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