Credit score

What is a credit score?

A credit score is a number that reflects your credit risk level, typically with a higher number indicating lower risk. It is generated through statistical models using elements from your credit report; however, your score is not physically stored as part of your credit history on the credit file. Rather, it is typically generated at the time a lender requests your credit report, and is then included as part of the report. Your credit score is a fluid number, and it changes as the elements in your credit report change. For example, payment updates or a new account could cause your score to fluctuate. There are many different credit scores used in the financial service industry. Your score may be different from lender to lender (or from car loan to mortgage loan), depending on the type of credit scoring model that was used.

What are the different types of credit scores?

There are primarily two types of scores, generic bureau-based scores and custom scores. Among bureau-based scores, the most widely used score in the financial service industry is the FICO score generated by the Fair, Issac Company. Each credit bureau can also generate its own credit score. The bureau-based credit scores draw on statistics from a large number of consumers across a variety of accounts. Custom scores are generated by individual lenders, who rely on credit bureaus and other information, such as account history, from their own portfolios. Scores are not just used to rate the credit worthiness of consumers. Lenders also use scores to predict consumer response to offers sent in the mail, the likelihood that account holders will file for bankruptcy or that a consumer will move their account to another lender.

Why are credit scores used?

Before credit scores, lenders physically looked over each applicant's credit report to determine whether to grant credit. A lender might deny credit based on a subjective judgment that a consumer already held too much debt, or had too many recent late payments. Not only was this time consuming, but human judgment was prone to mistakes and bias. Lenders used personal opinion to make a decision about an applicant that may have had little bearing on the applicant's ability to repay debt. Credit scores help lenders assess risk more fairly because they are consistent and objective. Consumers also benefit from this method. No matter who you are as a person, your credit score only reflects your likelihood to repay debt responsibly, based on your past credit history and current credit status.

Who uses credit scores and how are they used?

Banks, credit card companies, auto dealers, retail stores and most other lenders that issue credit or loans use credit scores to quickly summarize a consumer's credit history, saving the need to manually review an applicant's credit report and provide a better, faster risk decision. Although many additional factors are used in determining risk, such as an applicant's income vs. the size of the loan, a credit score is a leading indicator of one's basic creditworthiness.

What information impacts my credit score?

The information that impacts a credit score varies depending on the score being used. Generally, credit scores are affected by elements in your credit report, such as:

• Number and severity of late payments
• Type, number and age of accounts
• Total debt
• Recent inquiries
  Credit bureau-based scores, like those generated by Experian, cannot use demographics prohibited under the Equal Credit Opportunity Act, such as race, color, religion, national origin, gender, age, marital status, receipt of public assistance or exercise of rights under Consumer Credit Protection Act. Scores used by individual lenders may use such elements as income, occupation and type of residence in determining their own custom credit score.

Credit scoring 101

Similar forecasting methods

When it comes to weather forecasting, meteorologists consider a number of atmospheric conditions in making their predictions. In the case of issuing a tornado watch, for example, meteorologists watch temperature and wind flow patterns in the atmosphere that can cause enough moisture, instability, lift and wind shear to create tornadoes. Because these weather conditions repeatedly cause tornadoes, meteorologists can confidently predict the likelihood of tornadoes based on how many of the essential ingredients are present. The same logic applies to the consumer credit world. For example, the vast majority of consumers who file for bankruptcy exhibit certain patterns of credit behavior before bankruptcy occurs. When lenders see other consumers exhibiting the same behavior, they can reasonably predict that these consumers may also file for bankruptcy. Credit scoring, like forecasting, relies on clear patterns of the past to predict the future.

History of credit scores

Credit scores become widely used in the 1980's. Long before credit scores, human judgment was the sole factor in deciding who received credit. Lenders used their past experience at observing consumer credit behavior as the basis for judging new consumers. Not only was this a slow process, but it was also unreliable because of human error. Lenders eventually began to standardize how they made credit decisions by using a point system that scored the different variables on a consumer's credit report. This point system helped to eliminate much of the bias that previously existed; however, it was still tied to intuitive measures of credit worthiness and was not based on actual consumer behavior. Credit granting took a huge leap forward when statistical models were built that considered numerous variables and combinations of variables. These models were built using payment information from thousands of actual consumers, which made scores highly effective in predicting consumer credit behavior. When combined with computer applications, scoring models have made the credit granting process extremely fast, efficient and objective, facilitating commerce and helping consumers quickly get the credit they need.

The credit modeling process

Designers of credit scoring models review a set of consumers - often over a million - who opened loans at the same time, and determine who paid their loan and who did not. The credit profiles of the consumers who defaulted on the loans are examined to identify common variables they exhibited at the time they applied for the loan. The designers then build statistical models that assign weights to each variable, and these variables are combined to create a credit score. Models for specific types of loans, such as auto or home, more closely consider consumer payment statistics related to these loans. Model builders strive to identify the best set of variables from a consumer's past credit history that most effectively predict future credit behavior.

Risk categories

In determining credit scores, lenders place you in a risk category that compares you to a large number of consumers with similar credit histories. This allows lenders to compare "apples to apples," ensuring that you're credit behavior is judged in a context that is relevant and fair. For example, consumers with brief credit histories and only a few accounts are not compared to consumers with long-established credit histories. Rather, these consumers will be compared to other consumers who also have brief credit histories. Keep in mind that the attributes of your risk category (i.e. number of accounts, total debt, etc.) may not have the same impact to a credit score for consumers in another risk category.

What are score factors?

Score factors are the elements from your credit report that drive your credit score. For example, such elements as your total debt, types of accounts, number of late payments and age of accounts are what determine the outcome of your credit score. Score factors can have a positive or negative affect on your credit score. Lenders must provide consumers with the most significant score factors when they are declined credit.

Your credit score

How can I see my credit score?

Lenders, especially mortgage lenders, often make credit scores available to consumers during the loan process, although they are under no obligation to do so. However, there is a good possibility that consumers will soon have the benefit of new disclosure laws concerning credit scores. For example, the state of California recently passed a law that will obligate mortgage lenders to reveal credit scores to loan applicants beginning in July 2001. Industry analysts expect other states to follow suit.

Why don't I have a credit score?

Credit scoring models cannot generate a score without sufficient credit information. If you have little or no credit history, you will probably not have a credit score available. If you have never had a credit account, try applying for a retail, gas or secured credit card to begin your credit history. Keep your outstanding debt low and pay your bills on time. Before long you will be receiving additional offers for credit. However, be cautious to only apply for credit that you really need.

How do I improve my credit score?

Paying your bills on time is the single most important contributor to a good credit score. Even if the debt you owe is a small amount, it is crucial that you make payments on time. In addition, you should minimize outstanding debt, avoid overextending yourself and applying for credit needlessly. Applications for credit show up as inquiries on your credit report, indicating to lenders that you may be taking on new debt. Use the credit you already have to prove your ongoing ability to manage credit responsibly. If you do have negative information on your credit report, such as late payments, a bankruptcy, public record item or too many inquiries, your best strategy is to pay your bills and wait. Time is often your best ally in improving credit.

Managing score factors

If you are declined credit, a lender must notify you of the top reasons why. Pay careful attention to these factors and manage your credit accordingly. For example, if you have been declined credit because of high outstanding balances, chances are other lenders will feel the same way.

How often does my credit score change?

Your credit score is a fluid number that changes as your credit report changes. Therefore, any change to your credit report could impact your score. However, most credit scores do not change more than 30 points in a quarter.

How do my spouse or other family members affect my credit?

If you hold a joint credit account, have co-signed a loan or have authorized use of another person's credit, these items could affect your score if they appear on your credit report. It's important that joint account holders or authorized users understand that their credit behavior does affect the other joint account holder or main account holder. A credit account held solely in the name of your spouse, child or any other family member cannot impact your credit score. However, in community property states, all debt acquired during a marriage is considered a joint debt, regardless if the account is joint or in the name of an individual spouse.

This article is provided for general guidance and information. It is not intended as, nor should it be construed to be, legal, financial or other professional advice. Please consult with your attorney or financial advisor to discuss any legal or financial issues involved with credit decisions.