Credit Scores Work
Your credit score is a number generated by a mathematical formula based
on information in your credit report, compared to information on tens of
millions of other people. The resulting number is a highly accurate prediction
of how likely you are to pay your bills.
If it sounds arcane and unimportant, you couldn't be more wrong. Credit
scores are used extensively, and if you've gotten a mortgage, a car loan,
a credit card, or auto insurance, the rate you received was directly related
to your credit score. The higher the number, the better you look to lenders.
People with the highest scores get the lowest interest rates.
If you rented an apartment, got braces,
bought cell phone service, applied for a job that involved
handling a lot of money, or needed to get utilities connected,
there's a good chance your score was pulled. If you have an
existing credit card, the issuer is likely to look at your
credit score to decide whether to increase your credit line
or charge you a higher interest rate.
Buying a car? Most car dealers want to know your credit score when you
walk in the door. They want to know how they can put a loan together for
you. The score has made it easier for many people to get credit. Before,
it was up to individual lending institutions to come up with their own
criteria. They would hedge their risk and tend to go conservatively. It's
opened up lending to a lot more people.
Until recently, many Americans didn't even
know this number existed because it was a closely guarded secret
in the lending industry. In fact, lenders were prohibited from
telling borrowers their credit score. This changed recently
though when consumers began finding out about the score and
demanding to see it. In an unprecedented move in 2000, online
lender E-Loan offered to give consumers their scores for free,
with information explaining how the score is calculated and
how they might improve it.
Public outcry on the possibility of people being denied credit based on
bad information in credit reports led to several pieces of legislation
and a much more open attitude about credit scores. Fast forward to current
day: not only can consumers buy their score online from any number of sources,
but they are now entitled to one free credit report per year.
Key factors of your score
Just what goes into the score? The model
looks at more than 20 factors in five categories.
1. How you pay your bills (35 percent of the score)
The most important factor is how you've paid your bills in the past, placing
the most emphasis on recent activity. Paying all your bills on time is
good. Paying them late on a consistent basis is bad. Having accounts that
were sent to collections is worse. Declaring bankruptcy is worst.
2. Amount of money you owe and the amount of available credit (30 percent)
The second most important area is your outstanding debt -- how much money
you owe on credit cards, car loans, mortgages, home equity lines, etc.
Also considered is the total amount of credit you have available. If you
have 10 credit cards that each have $10,000 credit limits, that's $100,000
of available credit. Statistically, people who have a lot of credit available
tend to use it, which makes them a less attractive credit risk.
Carrying a lot of debt doesn't necessarily mean you'll have a lower credit
score. It doesn't hurt as much as carrying close to the maximum. People
who consistently max out their balances are perceived as riskier. People
who never use their credit don't have a track history. People with the
highest scores use credit sparingly and keep their balances low.
3. Length of credit history (15 percent)
The third factor is the length of your credit history. The longer you've
had credit, particularly if it's with the same credit issuers, the more
points you get.
4. Mix of credit (10 percent)
The best scores will have a mix of both revolving credit, such as credit
cards, and installment credit, such as mortgages and car loans. Statistically,
consumers with a richer variety of experiences are better credit risks.
They know how to handle money.
5. New credit applications (10 percent)
The final category is your interest in new credit -- how many credit applications
you're filling out. The model compensates for people who are rate shopping
for the best mortgage or car loan rates. The only time shopping really
hurts your score is when you have previous recent credit stumbles, such
as late payments or bills sent to collections.
The scoring model doesn't look at:
• if you've been turned down for credit
• length of time at your current address
• whether you own a home or rent
• time on job
A lender may consider all these factors when deciding whether to approve
a loan application, but they aren't part of how a FICO score is calculated.
Credit scores are not perfect
The major drawback to credit scoring is that it relies
on information in your credit report, which is quite likely to contain
errors. That's why it's critical that you check your credit reports annually
or at the very least three to six months before planning to buy a house
or a car. This will give you sufficient time to correct any errors before
a lender pulls your score.