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How does a creditor decide whether to lend you money for such things as a new car or a home mortgage? Many creditors use a system called "credit scoring" to determine whether you are a good credit risk. Based on how well you score, a creditor may decide to extend credit to you or turn you down. The following questions and answers may help you understand who gets credit, and why.
Credit scoring is a system used by some creditors to determine whether to give you a loan or credit card. The creditor may examine your past credit history to evaluate how promptly you pay your bills and look at other factors as well, such as the amount of your income, whether you own a home, and how many years you have worked at your job. A credit scoring system awards points for each factor that the creditor considers important. Creditors generally offer credit to those consumers awarded the most points because those points help predict who is most likely to pay back the debt.
Most lenders determine 35% of the score from payment histories on your credit accounts, with recent history weighing more heavily than the distant past. 30% is based on the amount of debt you have outstanding with all creditors. 15% depends on how long you've been a credit user. A longer history is better if you've always made timely payments. 10% is your very recent history and whether you've been seeking (and getting) loans or credit lines. And 10% is calculated from a mix of credit you hold, including installment loans (like car loans), leases, mortgage, and credit cards.
To help lenders make decisions, credit bureaus often provide a risk score. Credit bureau scores are often called "FICO scores" because most credit bureau scores used in the US are produced from software developed by Fair, Isaac and Company (FICO). FICO scores are provided to lenders by the three major credit reporting agencies: Equifax, Experian, and Trans Union.
More than one Score
In general, when people talk about "your score," they're talking about your current FICO score. However, there is no one score used to make decisions about you. This is true because:
In smaller communities, shopkeepers, bankers, and others who extend credit often knew by word of mouth who paid their debts and who did not. As some creditors became larger and as the number of their consumer credit applications grew, these creditors needed to establish more systematic and efficient methods for evaluating which consumers were good credit risks. Credit scoring is one such technique.
Although smaller creditors still may rely on informal credit evaluations, many large companies now use formal credit scoring systems. Although no system is perfect, credit scoring systems can be at least as accurate as informal methods for granting credit — and often are more so — because they treat all applicants objectively.
Most credit scoring systems are unique because they are based on a creditor's individual experiences with customers. To develop a system, a creditor will select a random sample of its customers and analyze it statistically to identify which characteristics of those customers could be used to demonstrate creditworthiness. Then, again using statistical methods, a creditor will weigh each of these factors based on how well each predicts who would be a good credit risk.
To illustrate how credit scoring works, consider the following example that uses only three factors to determine whether someone is creditworthy. (Most systems have 6 to 15 factors.)
|Less than $400||0|
|$400 to $650||3|
|$651 to $800||7|
|$801 to $1,200||12|
Some credit scoring systems award fewer points to people in their thirties and forties, because these individuals often have a relatively high amount of debt at that stage of their lives. The law permits creditors using properly-designed scoring systems to award points based on age, but people who are 62 or older must receive the maximum number of points for this factor.
If, for example, you needed a score of 25 to get credit, you would need to make sure you had enough income at a certain age (and, perhaps a telephone) to qualify for credit.
Remember, this example shows very generally how a credit scoring system works. Most credit scoring systems consider more factors than this example ¾ sometimes as many as 15 or 20. Usually these factors are obviously related to your credit worthiness. Sometimes, however, additional factors are included that may seem unusual. For example, some systems score the age of your car. While this may seem unrelated to creditworthiness, it is legal to use factors like these as long as they do not illegally discriminate on race, sex, martial status, national origin, religion, or age.
With credit scoring systems, creditors are able to evaluate millions of applicants consistently and impartially on many different characteristics. But credit scoring systems must be based on large enough numbers of recent accounts to make them statistically valid.
Although you may think that such a system is arbitrary or impersonal, a properly developed credit scoring system can make decisions faster and more accurately than an individual can. Many creditors design their systems so that marginal cases ¾ not high enough to pass easily or low enough to fail definitively ¾ are referred to a credit manager who personally decides whether the company will extend credit to a consumer. This may allow for discussion and negotiation between the credit manager and a consumer.
With the help of sophisticated credit-scoring models, lenders are rummaging deeper into consumer backgrounds, enabling them to reclassify some formerly prime customers as subprime. The benefit to the lender: increased profits. All this adds up to a profound change in lending that has gone largely unreported. While officials have been cracking down on the worst abuses of subprime lending, other practices have exploded into mainstream lending allowing lenders to charge premium rates, exploit shaky credit histories, and suck borrowers into subprime for life.
National Home Equity Mortgage Association on subprime lenders report that the subprime borrower's annual income is only about $3,000 less than prim borrowers, on average. They are school teachers, police officers, independent business people, lawyers, in some cases, and doctors and those with high income but equity challenged by big loans. Subprime debt comes in almost every form, including mortgages, refinance loans, credit cards, and new & used car loans. Total subprime lending increased tenfold in the last five years.
Credit bureaus have also become more meticulous. Today, they collect information that wasn't typically reported before the 1990's -- bill-paying data from phone companies, utilities, and even hospitals. That rigor turns up more people who have missed a payment somewhere, sometime, on some bill.
Credit bureau scores are often called "FICO scores" because most credit bureau scores used in the US are produced from software developed by Fair, Isaac and Company (FICO). FICO scores are provided to lenders by the three major credit reporting agencies: Equifax, Experian, and Trans Union.
If the consumer requests the credit file and not the credit score, a statement that the consumer may request and obtain a credit score.
Any consumer reporting agency that furnishes a consumer report that contains any credit score or any other risk score or predictor on any consumer shall include in the report a clear and conspicuous statement that a key factor (as defined in section 609(f)(2)(B)) that adversely affected such score or predictor was the number of enquiries, if such a predictor was in fact a key factor that adversely affected such score.
One of the three largest credit bureaus, Equifax now offers an online credit score service on its web site. Along with your score, the company offers an explanation of how your score was arrived at and things you might do to improve it.
FICO scores provide the best guide to future risk based solely on credit report data. The higher the score, the lower the risk. But no score says whether a specific individual will be a "good" or "bad" customer. And while many lenders use FICO scores to help them make lending decisions, each lender has its own strategy, including the level of risk it finds acceptable for a given credit product. There is no single "cutoff score" used by all lenders and there are many additional factors that lenders use to determine your actual interest rates.
The Fair, Isaac and Co (FICO) is the company whose risk-scoring models are most commonly used to generate scores. They have found that certain things predict how well people will pay their bills. The most important factors are:
Previous payment record. Do you pay your bills on time or late? Obviously on-time is better and late is progressively worse depending on how late, how frequently, and how recently. The most important bill to pay on time is your mortgage. Renters get no credit for diligent monthly payments.
Current indebtedness. What are your credit limits and how much have you used up? Maxing out credit line is bad. Getting credit only when it's needed is good.
These first two factors drive 60 to 65 percent of the overall score. Three other factors make up the rest:
New credit. New credit, statistically, is looked at as "can you handle the added burden?" The model presumes no, until you prove over time that you haven't taken on more than you should be in order to make payments on time.
Applying for new credit. When you apply for credit, the prospective lender calls up your credit report and the credit bureau notes the inquiry on your record. That makes lenders wary. Someone seeking a lot of credit in a short time is inherently more risky than someone not seeking credit. The model doesn't penalize you if you're hunting for an auto loan or a mortgage within a short time frame. But your score will get hurt if you shop around for the best credit card or personal loan by actually applying. When a credit card company pulls your record to make you a "pre-approved" credit offer, the model ignores those inquiries.
Types of credit used. Lenders look to other debt besides credit cards. A mortgage and auto loan show that you can handle the money-management peculiarities of obtaining and maintaining each. Finance company loans are a black mark.
In order for a FICO® score to be calculated on your credit report, the report must contain at least one account which has been open for six months or longer. The report must also contain at least one account that has been updated in the past six months. This ensures that there is enough information — and enough recent information — in your report on which to base a score.
Depending on the credit reporting bureau, FICO scores are now at BEACON (Equifax), EMPIRICA (TransUnion) and the Experian/Fair, Isaac Risk Model. FICP scores are based on information in consumer credit reports maintained at one of these credit reporting agencies.
Credit Scores Breakdown
Here is how Fair, Isaac & Co. measures financial risk:
Types of Credit Use 10%
New Credit 10%
Length of Credit History 15%
Amounts Owed 30%
Payment History 35%
FICO scores- higher score, better rating.
Credit scores give lenders a fast, objective measurement of your credit risk. Scoring has greatly increased the credit granting process. Before scoring it could be slow, inconsistent, and unfairly biased.
Lenders can also buy a credit score based on the information in the report along with the credit report. That score is calculated by a mathematical equation that evaluates many types of information that are on your credit report at that agency. By comparing this information to the patterns in hundreds of thousands of past credit reports, the score identifies your level of future credit risk.
Credit scores — especially FICO® scores, the most widely used credit bureau scores — have made improvements in the credit process such as:
Check your credit score and learn more about scoring at myFICO.com.
When a lender uses the Fair, Isaac credit bureau risk score, up to four "score reason codes" are delivered. These explain the top reasons why your score was not higher. If the lender turns down your request for credit, and your FICO® score was part of the reason, these score reasons can help the lender tell you why your score wasn't higher.
Reasons for scoring are more useful than the score itself in helping you determine if your credit report might contain errors, and how you can improve your score over time. I you already have a high score (for example, in the mid-700s or higher) some of the reasons may not be very helpful, as they may be marginal factors related to length of credit history, new credit and types of credit in use.
Below are the top most frequent reasons given for scoring . The specific wording used by your lender may be different from this list.
Many long-held beliefs about what improves and hurts your credit score are wrong. Credit scores, a three-digit number ranging from 300 to around 900, are used by employers, lenders, landlords, and insurer; these myths can hamper your ability to get loans, jobs, and housing and can boost your insurance rates.
Myth: Canceling unused credit cards, thus reducing the amount of available credit will boost your score.
Truth: Canceling could hurt your score for two significant reasons:
Myth: Your score declines if your borrowing exceeds a particular percentage of your income.
Truth: The FICO program doesn't consider your income at all. This data is not collected by the program. (It also doesn't collect data on your age, assets, marital status, gender, ethnicity, or address.)
However, when a lender considers giving you a loan, it will check your income to determine a debt-to-income ratio. Generally speaking, lenders frown on people who have unsecured debt payments exceeding 20 percent of take-home pay and mortgage loan payments exceeding 30 percent of net income. Moreover, if you have substantial "available" but unused credit, such as high credit limits on numerous credit cards, they're less likely to extend another loan, fearing that you could become overextended.
When you're applying for a major loan such as a mortgage, anyone with a credit score above a certain level is considered a "no-brainer" for approval. But if you drop below that score by even 10 points, the lender must do considerably more underwriting to give you a loan and in the process will hold you to a higher debt-to-income standard.
Myth: There are different FICO scored for different industries.
Truth: The FICO score does not have industry-specific versions. The score is generic. But consumers are categorized. Here's how is works: Fair Isaac's program does a quick preliminary sweep of a credit file to deposit consumer into one of 10 categories before they are rated. The company is not yet willing to disclose what all of those categories are, but they include consumers with short credit histories; consumers with "thin" files (you may have long experience with credit, but you don't have many different types of loans); consumers with rich files (long and diverse histories with credit); and those with problem files (those that have negatives such as bankruptcies, foreclosures, and account that have gone to collection agencies).
Once consumers are categorized, the program creates a score that's aimed at ranking consumers in the same category, best to worst, based on their propensity to pay back a debt.
There are a lot of myths and misunderstanding about how to improve your credit and consumers can take inappropriate action.
Here are some tips to keep in mind about credit scores and reports:
While a creditor is not required to tell you the factors and points used in its scoring system, the creditor must tell you why you were rejected for credit. This is required under the federal Equal Credit Opportunity Act (ECOA).
So if, for example, a creditor says you were denied credit because you have not worked at your current job long enough, you might want to reapply after you have been at that job longer. Or, if you were denied credit because your debt-free monthly-income was not high enough, you might want to pay some of your bills and reapply. Remember, also, that credit scoring systems differ from creditor to creditor, so you might get credit if you applied for it elsewhere.
Sometimes you can be denied credit because of a bad credit report. If so, the Fair Credit Reporting Act requires the creditor to give you the name and address of the credit reporting bureau that reported the information. You might want to contact that credit bureau to find out what your credit report said. This information is free if you request it within 30 days of being turned down for credit. Remember that the credit bureau can tell you what is in your report, but only the creditor can tell you why it denied your application.
The Indiana Department of Insurance and 33 other states will regulate how credit information is used to determine coverage risk. By October 1, 2002, all insurers that rely on credit data to rate personal insurance in Indiana must submit all related materials, including closely guarded mathematical scoring formulas, to the department for approval.
Insurers face a $25,000 fine for each policy written outside of compliance and $50,000 if done so knowingly. The Department issued a bulletin in early July that spelled out this rule.
See Web Site: Credit Grade Calculator!
If you have additional questions about credit scoring issues, write to:
Federal Trade Commission
Washington, D.C. 20580
While the FTC cannot resolve individual problems for consumers, it can act when it sees a pattern of possible law violations.
Note: The links on this page that go to web sites outside of this agency's control are provided as a convenience only. The Department takes no responsibility for their content.