Understanding Credit Scoring

Have you ever wanted to predict the future? Creditors have a way of doing just that.

Credit scoring is a statistically based computerized method for predicting how likely it is that a borrower will pay back a loan before it's even issued. It automates the process of applying for credit, which saves time and increases accuracy. When a car dealership advertises "instant credit approval," that dealership is using credit scoring.

How Does It Work?
Your credit score is a snapshot of your credit performance at one point in time.

Credit reports from millions of borrowers are compared to each other using a computer program that considers similarities between the reports and whether the borrowers paid some or all of their bills on time. The program puts the reports in rank order, giving each a score-like a grade on a test.

Predictive variables are categories for predicting risk. Your credit score is calculated based on these variables. By looking at your credit score, the creditor can figure out how much risk is involved with loaning you money. The score gives the creditor a way to predict how well you will manage your debt.

Changing the Score

No credit score lasts forever. It changes over time as your credit behavior changes. Think of it as a snapshot of your credit performance at one point in time. Your score can go up or down depending on how you manage your credit.

The credit score, which is based entirely on the credit report, is the creditor's most powerful tool for assessing credit risk. To make sure you score high with your credit history, it's important to understand what factors affect your credit score.

Credit risk: The credit industry term meaning the level of risk or likelihood of future default by an individual borrower.

Credit score: A computer-generated number, based on a statistical model, that summarizes an individual's credit record and predicts the likelihood that a borrower will repay future obligations.

Predictive variables: The items that are part of the formula or factors comprising elements of a credit scoring model. These variables are used to predict a borrower's future credit performance.

Click here for the complete Glossary of Credit terms.

Factors in Credit Scores
Different types of information, known as factors, are gathered from your credit report to make up your credit score. These factors fall into broad categories, such as payment history and outstanding debt.

Credit scores reflect credit patterns over time.

Credit scoring models rate the importance of each category to calculate your credit score.

Credit scores reflect credit patterns over time. An adverse action, like a tax lien or bankruptcy filing, can immediately and significantly impact a credit score.

Several factors can have a negative impact on your credit score:

• History of nonpayment
• Public record information
• Evidence of collection accounts
• Recent delinquent accounts
• High balances owed on accounts
• Credit cards charged to their limits
• Too many new accounts

Only the applicant's prior credit history is considered when calculating a credit score. For this reason, credit scoring is considered unbiased. Any factors that would show bias are not allowed.

Your credit score cannot be based on any of these factors:

• Race
• Gender
• Age
• Income level
• National origin
• Sources of income
• Religion
• Marital status

Because income level is not a factor, you could have a low income and a high credit score. Or you could have a high income and a low credit score. It just depends on your credit history.

FICO® scores, developed by Fair, Isaac and Co., Inc., are the most commonly used credit scores today. According to FICO, the various factors used to calculate credit scores can be grouped into five primary areas:

1. Payment history
2. Outstanding debt
3. How long you have been using credit
4. Pursuit of new credit
5. Types of credit in use

FICO is one credit scoring company. Other companies may use different factors.

Understanding Credit Scoring

How Credit is scored
Five sample factors for calculating credit scores are listed below, along with a sample of the importance each factor has to the total score. As you read through the list, think about how your credit might score today.

• Payment History: 35%. What is your track record? Have your payments been made on time?
  
  
• Outstanding Debt: 30%. How much do you owe? Do you have a high level of debt? Are you near the limit on your accounts?
  
  
• Credit History: 15%. What is the length of your credit history? Has it only been a few years?
  
  
• Pursuit of New Credit: 10%. Have you made numerous applications for new credit? Are you taking on more debt?
  
  
• Types of Credit in Use: 10%. Do you use a variety of credit types? The score will consider your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans.

Calculating Your Score

So how does all this math work? Each factor is given a weight or level of importance. This weight is assigned as a percentage (such as 35%, as shown in the example above). The score is graded for each factor, and then each factor is multiplied by the weight. Computers calculate credit scores in an instant.

Click here to see a sample credit score calculation (PDF format).

What If I Can't Get My Score?

Consumers have a right to know the specific reasons why an application for credit is rejected. There are no laws requiring lenders to reveal your credit score to you, but this is expected to change. Laws will be updated to reflect the influence and convenience of computers on consumer credit and spending patterns. But until then, it never hurts to ask. Some lenders will gladly share your score. Be sure to ask lots of questions and understand what the score means.

Terms
What's a Good Score? How high does your credit score need to be? Different credit scoring systems use different numbers. Scores can generally range from 300 to 900. Be sure to ask the creditor or lender to explain your score to you. Some credit scoring companies publish their scores.
 
A Good Mix You should have a good mix of installment loans, credit cards and other types of accounts. It is not necessary to have one of each, nor is it a good idea to open credit accounts that you have no intention of using.