How Credit Scoring Works
Credit scoring is a numerical indicator used to predict risk. Lenders rely on credit scores to determine, based on a range of numbers, the borrower’s potential for credit risk, default, or delinquency. Interest rates and credit terms and conditions are adjusted accordingly. There are rewards for higher scores and penalties for lower scores. Those with higher scores qualify for easier access to credit, lower interest rates, and more financial options.
Raising your credit score requires a great deal of work and cannot be accomplished without understanding how the results are calculated. Without question, you can raise—or lower—your score based on the decisions you make. For example, overextending your credit, obtaining personal loans, or accumulating debts will have a dramatic impact on your score. Remember, following a few simple steps and learning these scoring factors will improve your result.
Factors For Credit Scoring
The most common scoring system, Fair, Isaac and Company (or FICO), is used by nearly all creditors and credit bureaus. Most use either the FICO scoring system or have one based on the FICO model. Generally, we think of credit scoring as a single score. However, under FICO, there are three separate scores, or one score for each of the three credit bureaus. If you have pulled a recent report, you may have noticed some variation—either a lower or higher score—on each of the three credit reports. The reason scores vary is that each credit bureau uses slightly different models in calculating your score. Be sure you take the time to understand the difference.
Bureau Score Names & Scoring Ranges
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Equifax Beacon
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300-850
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Experian/Fair Isaac Risk Model
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330-830
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TransUnion FICO Risk Score
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400-925
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FICO Scoring Range 300-850 Points
Understanding FICO Score
In learning how scores are calculated, we will review the FICO Beacon score, as well as the factors that are used to calculate your credit score. It’s important to note that the same factors are used in all three scoring models.
EQUIFAX BEACON SCORE
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Base Line Points
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300
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Payment History
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193
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Outstanding Debt
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165
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Credit History
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82
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Credit Inquiries
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55
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Types of Credit
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55
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Total
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850
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Payment History 35%
• Includes a record of your history with various financial institutions: finance companies, retail cards, and credit cards, such as Discover or Visa, and installment loans.
• Public record and collection items—reports of events such as bankruptcies, foreclosures, suits, liens, wage attachments, and judgments.
• Details on late or missed payments (delinquencies) and public record and collection items such as collection accounts, charged-off accounts, or debt settlement.
• Number of accounts showing no late payments.
• Recent negative information will significantly lower your score; minimum of 2 years of positive history to establish credit worthiness.
Outstanding Debts 30%
• The amount owed on all accounts; the total balance on your last statement is generally the amount that will show in your credit report.
• The amount owed on all accounts and on different types of accounts. FICO considers the amount you owe on specific types of accounts such as credit cards and installment loans.
• Whether you are showing a balance on certain types of accounts; balances should be under 30%.
• How many accounts have balances: a large number can indicate higher risk of overextension.
• How much of the total credit line is being used on credit card accounts: high balances (or cards close to “maxing out”) indicate an increased potential for risk and lower your score.
Length of Credit History 15%
How long credit accounts have been established; accounts that are older than seven years are favorable and raise your score.
• How long specific credit accounts have been established. New accounts temporarily lower your score. Accounts that are open for one year are positive.
• How long it has been since you used certain accounts. Regular credit activity is important.
Inquiries 10%
• Too many new accounts. Recently opened credit cards may have a negative impact on your score.
• Length of time since you opened a new account.
• How many recent requests for credit you have made, as indicated by inquiries to the credit bureaus. More than four within a three-month period may lower your score.
• Length of time since credit inquiries have been made by lenders.
Types of Credit 10%
• What types of credit accounts you have, such as credit cards, retail cards, installment loans, or finance company loans. It is not necessary to have one of each.
• How many of each; FICO looks at the total number of accounts. One to three revolving accounts are optimal, but no more than seven are recommended.
Commonly Asked Credit Scoring Questions
Do my FICO scores alone determine whether I get credit? No. Most lenders use a number of facts to make credit decisions, including your FICO score, your income, employment history, and your credit history.
How fast does my FICO score change? In a given three-month time, only one in four people has a 20-point change in their score. For this reason, you should check your score 6-12 months before applying for the loan.
How can mistakes get on my credit report?
• You applied for credit under different names (Mary Jones, Mary Jones-Smith). Someone made a clerical error in reading or entering a name or address.
• You gave an inaccurate Social Security number or the number was misread by the lender.
• Loan information was applied to the wrong account.
Should I close old accounts to raise my score?
• No. Long established accounts show a longer history of managing credit.
What is a good FICO score?
• Lenders make decisions based on their own criteria; however, a score in the range of 680 to 720 generally is considered to be “good.”
Disputing Credit Report Errors
Having a credit bureau verify incorrect, outdated, or duplicate information, is a legal responsibility that credit bureaus must undertake. Be diligent about having items that are not accurate removed from your credit report. Errors that are left in your file can have a damaging affect on your credit score. By law, credit bureaus must do the following:
* Complete their investigation within 30 days of receiving your complaint.
• Contact the creditor reporting the incorrect information within 5 days of receiving your complaint.
• Review all relevant information supplied by you.
• Remove all inaccurate and unverified information.
• Adopt procedures to keep errors from reappearing.
• Provide you with results of their investigation, including a new credit report, within 5 days of completion.
If you receive a favorable decision from a credit bureau, take the following steps:
• Obtain another copy of your credit report to make sure that the bureau made the corrections.
• Contact other credit bureaus to determine if the error has been removed from their files as well.
• Send the results of the investigation to the other bureaus.
• Get a copy of your credit report 3 to 6 months later to make certain the credit bureau has not reinserted the information.
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