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Credit Education
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Credit Score
A credit score is a number that is based on a statistical analysis of a person's credit report, and is used to represent the creditworthiness of that person—the likelihood that the person will pay his or her debts. A credit score is primarily based on credit report information, typically from the three major credit bureaus. All credit scores are not the same because each credit bureau uses its own scoring mechanism. Many lenders use a third party credit scoring system such as FICO to evaluate the credit worthiness of a borrower.
Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers and to mitigate losses due to bad debt. Using credit scores, lenders determine who qualifies for a loan, at what interest rate, and to what credit limits. The use of credit- or identity-scoring before authorizing access to or granting credit is an implementation of a trusted system. While the most widely known score in the United States is FICO (the most widely used in the mortgage industry), there are many others.
FICO
FICO, the acronym for Fair Isaac Corporation, is a publicly-traded corporation that created the best-known and most widely used credit score model. The FICO score is calculated statistically, with information from a consumer's credit files. The FICO score is primarily used in credit decisions made by banks and other providers of secured and unsecured credit. Banks and other institutions using such scores as a factor in their lending decisions may deny credit, charge higher interest rates, demand more collateral, or require extensive income and asset verification if the applicant's FICO credit score is low.
FICO uses different scoring methods to rate a borrower's suitability for three types of credit—mortgages, automobile loans, and consumer credit— reflecting the loan default risks inherent to these different types of lending. It is not unusual for these scores to differ—by 50 points or more—for the same borrower. The score also depends on what credit reporting agency the data is obtained on, since not all creditors report to all three. The score FICO sells to borrowers is their consumer credit score, and the borrower can choose which agency the data is obtained from.
Credit reporting agencies
Three credit reporting agencies, Equifax, Experian, and TransUnion, calculate a borrower's credit score using their own different computation formulas. The scores they generate differ in what they mean to predict, the statistical methods used to determine a credit-worthiness score, and what data are used and how they are weighted.
Score facts
Most scores use a multiple-scorecard design. Each version may use individual scorecards. Typically, a given borrower is compared with other consumers; e.g., a borrower with two 30-day late payments will be scored against a similar delinquent-payer population. The borrower then is graded according to the risk-determining mathematical variables used by the scoring model, ranking him or her within the group of similar borrowers. Most large banks build and use their own proprietary statistical credit-scoring models, often in conjunction with third-party scoring models.
The statistical models for generating credit scores are subject to federal regulation. The Federal Reserve Board's Regulation B (implementing the Equal Credit Opportunity Act), expressly prohibits a credit-scoring model considering "prohibited biases" such as race, skin color, religion, national origin, sex, and marital status. It also states that credit-scoring models must be empirical and statistically sound. Furthermore, if negative action results from a credit score (i.e. a denied application for credit), the lender must state to the borrower the specific reasons for the denial. A statement that the person "failed to score high enough" is insufficient; the reasons must be specific (e.g. "too many delinquencies of 60 days or greater").
Makeup of the Credit Score
Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history. Although the exact formulas for calculating credit scores are closely guarded secrets, the Fair Isaac Corporation has disclosed the following components and the approximate weighted contribution of each:
- 35% — punctuality of payment in the past (only includes payments later than 30 days past due)
- 30% — the amount of debt, expressed as the ratio of current revolving debt (credit card balances, etc.) to total available revolving credit (credit limits)
- 15% — length of credit history
- 10% — types of credit used (installment, revolving, consumer finance)
- 10% — recent search for credit and/or amount of credit obtained recently
The above percentages provide very limited guidance in understanding a credit score. For example, the 10% of the score allocated to "types of credit used" is undefined, leaving consumers unaware what type of credit mix to pursue. "Length of credit history" is also a murky concept; it consists of multiple factors — two being the oldest account open and the average length of time other accounts have been open. Although only 35% is attributed to punctuality, if a consumer is substantially late on numerous accounts, his score will fall far more than 35%. Bankruptcies, foreclosures, and judgments affect scores substantially.
Current income and employment history do not influence the FICO score, but they are weighed when applying for credit. For instance, an unemployed individual with no sources of income will not usually be approved for a home mortgage, regardless of his or her FICO score.
There are other special factors which can weigh on the FICO score.
- Any money owed because of a court judgment, tax lien, or similar carry an additional negative penalty, especially when recent.
- Having more than a certain number of consumer finance credit accounts also carries a negative weight (critics say that this causes a vicious cycle, locking people into continuing to use consumer finance companies).
- The number of recent credit checks also can weigh down the score, although credit agencies usually claim to allow for credit checks made within a certain window of time not to aggregate, so as to allow the consumer to shop around for rates.While all credit inquiries are recorded and displayed on your credit report for a period of time, credit inquiries that were pulled by yourself (to check your credit), or by your employer (for employee verification) do not have any impact on your credit score.
Range of scores
A FICO score is between 300 and 850, exhibiting a left-skewed distribution with 60% of scores between 650 and 799. According to Fair Isaac the median score is 723 (half of scores above and below) whereas according to Experian (using the Fair Isaac risk model) the average credit score is 678 (lowest scores are farther from the median than the highest scores). The performance of the scores is monitored and the scores are periodically aligned so that a credit grantor normally does not need to be concerned about which score card was employed.
Each individual actually has three credit scores, each ranging between 300 and 850. The scores can vary between the various scoring models because the three credit agencies have their own databases. As these databases are independent of each other, they may contain entirely different data. Many lenders will check an applicant's score from each bureau and use the median score to determine the applicant's credit worthiness.
Free annual credit reports
Each U.S. resident is entitled to one free copy of his or her credit report from each credit reporting agency once every twelve months. This information is available exclusively through only these three options:
- The quickest option is to log on to the government-sanctioned, credit reporting agency-operated website, annualcreditreport.com. You should have the ability to retrieve each of your three credit reports through this site. Although you will be offered the opportunity to purchase your credit scores and/or credit monitoring services on this site, if you choose not to purchase anything(typically offered in the form of a “free trial”), it will not cost anything for you to access your FREE reports through this site.
- Another option is to call 1-877-322-8228 and go through the automated system. This option can result in a delay of up to 30 days before receiving your reports.
- The third option is to mail the Annual Credit Report Request Form. This option too can result in a delay of up to 30 days before receiving your reports.
Contact us now to learn more about how Pegasus may be able to help you. |
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