Credit Scores: Most Everything You Need to Know

Have you ever been pre-qualified for a mortgage, car loan, or credit card without ever submitting an application?  When applying for a loan online, have you been approved within minutes?

This is all possible due to credit scores.

Lending and banking institutions, landlords, and even potential or current employers apply credit scores to make credit, tenancy, and even employment or advancement decisions every day.

The lending industry started using credit scores in the ‘80s as computer usage grew in the work place.  Previous to that, credit decisions were arbitrarily made using individual judgment. Relying on individual judgment led to unpredictable and unreliable results, and was both slow and tedious.

There was growing concern in Congress in the ‘70s regarding discrimination in housing.  This concern led to legislation to reduce the human factor when evaluating credit applications.  Starting with FCRA in ‘71 and then FDCPA in ‘77, legislation forced the credit bureaus (also known as CRAs for Credit Reporting Agencies) to modify and standardize rating procedures.

The point system was the first attempt at a better rating system.  It employed a weighted list of credit report items.  This was a good first step towards removing much of the bias and the ambiguity associated with credit analysis.  This system was soon replaced by a statistical model which included thousands of report items and over hundreds of variables all associated with consumer payment histories.

Out of this came FICO (developed by the Fair Isaac Company); one of the first models developed, and which soon became the recognized predictor of consumer credit behavior.  Many of the lending institutions quickly adopted FICO as the de facto standard.  It was the answer to Congressional pressure to remove discrimination in the rating system.

Statistical modeling also presented major advantages as well: much faster processing, standardization, highly predictive; and totally objective.

How does it work?

The foundation for credit scoring is a technique called Risk Factors.  Risk Factors work by grouping individuals into risk categories, and then calculating a rating based on relative standing within the Risk Factor group.  For example, if a person is placed in the high risk group, then that person is rated relative to all the other members in that high risk group.

A similar approach is applied to the credit report, where entries to the report are also grouped into Score Factors.  Score Factors provide the basis for a final credit score.  Some of the items found in Score Factors are: the number of loans outstanding, the number of credit cards; your payment history (i.e., bankruptcies, late payments, foreclosures, etc.), overall debt to income ratio, your employment status, etc..  Note, if you are denied credit, you can and should request a copy of the Risk Factors that were used in the decision.

Credit scores range from a low of 300 to a max of 850, where the higher the credit score, the better.  There are three major CRAs (Experian, Equifax, and TransUnion), and each provide a credit score: Their scored differ for two reasons: first, each uses a modified version of FICO; and second, their record of your credit history will differ.  It is common for lending institutions to request all three credit scores when evaluating a loan application.

If you have a score higher than 720-750, this is considered an excellent score (anything above consider a cushion for possilbe negative entries).  Below is a guideline that should help in understanding credit report scoring:

• 35% from payment history.  Included in your payment history are: late payments, collections, charge offs, liens and judgments, bankruptcies, short-sales and deed in lieu, etc..  These items do negatively affect your score, and could stay on the report for years.

• 30% reflects debt distribution (also called utilization).  Generally, it is suggested that you keep a number of accounts with low balances, rather than having one or two accounts near their max limit.  To better understand this, let’s use a simple utilization formula: Debt / Credit.  Your debt to credit ratio should be below 10%. That is, if you have credit card debt of $5 thousand, and your credit limit is $15 thousand, then your ratio is 33% (5 / 15).  Since this is higher than 10%, you need to either lower your debt (payoff some of the balances) or increase your credit limit.

• 15% from Established History.  Simply, the older your accounts are the better.  When you are first establishing credit, it would definitely help if you could be added to someone else’s established account as an Authorized User (this usually involves a family member, such as a parent or sibling).  Established accounts have, by definition, been active (or established) for awhile (at least several years or more).  If your listed as an Authorized User on an established account, you see an improvement in your credit score.

• 10% Inquiries.  Authorize (also known as Hard) inquiries into your credit score or report will impact slightly on your credit score, but this negative impact can add up fast.  The more hard inquiries you authorize in a given period, the lower your credit score.  Therefore, you should try to maintain the number of hard inquiries to a minimum (that is, avoid applying to several banks for a loan in a short period).

• 10% Mix of Credit.  You will find that your credit score improves when you have a broad mix of loans or debts. This would include revolving credit, mortgage loan, installment loans, auto loan, and so on. If you can, try to have the balances across these accounts at about the same level.

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