Customers ask us all the time questions like, “What does my credit score represent?” and “How is it determined?” To many consumers, credit scores (and the many credit scoring systems) remain a mystery and they are don’t know what their credit score is, how they can improve or damage that score, and how it can be used against them. “Only 27% understand that scores measure credit risk, not credit knowledge, amount, or attitude”, according to a paper published by the Consumer Federation of America and Providian. To answer these questions, let’s take a stroll through the inner workings of a credit score.
In our previous article, A Two minute Guide To Credit Scores, we discussed the variety of credit scoring models and why the results differ – and why you shouldn’t fret over the differences. In this article, we will explore how credit scores are determined, what factors affect them and what does not.
A credit score is derived from a complex mathematical model considers the many types of information that can be contained in a credit file. They are used to determine your “willingness” to pay your financial obligations (your financial reliability or credit risk); that is, how likely you are to make your loan payments on time. However, they do not calculate your “ability” to pay your debts (although lenders certainly take that into consideration as well before making a decision to lend you money).
Statisticians have studied consumers’ (of credit) payment patterns for years and they have learned what factors are associated with consumers who pay their bills on time – and what kind of things represent those who don’t – have in common. They look in your payment history for issues such as bankruptcy, collections and late payments. Some will give you additional points for living in your home a certain number of years, but may subtract points if you haven’t lived there long enough. They also consider things like the types of credit and the ratio of debt to available credit. Then they assigned numerical values to those predictors and created statistical models.
Typically, the data in your credit file is broken down into several categories, analyzed and then “weighted” as to which areas are better predictors of your credit risk. For example, a particular scoring model may allocate 35% of your score to payment history, which can include account payment information, bankruptcy or judgments, how many overdue payments you have and how long they are overdue, the amount past due, and other related factors. The amount owed can represent as much as 30% of your score. Other factors such as the length of your credit history (15%), new credit (10%) and type of credit used (10%) all add to the calculation of your overall score. Remember, these percentages are only examples of how one scoring model might weigh the various factors and other models are likely to differ to some degree. Every bank does it differently, so your score could vary depending where you apply for credit.
Each scoring model, applied consistently can yield a fairly decent assessment of your credit risk. But they do not consider things such as “empathy” or “ability” (your sources of income and debt to income ratio). If you happened to be hospitalized or incapacitated or suffered the result of an illness in the family, for example, and consequently missed some payments, the scoring models won’t account for that. In those cases, fortunately, many banks may allow you to plead your case to a live loan officer who may take your circumstances into consideration..
Obviously, someone who has never missed a payment in fifteen years is a much safer bet than someone who has been on time for just two. But other factors are not as obvious. For instance, someone with only one credit card may be considered less risky than a person with 10 or more, but the person with many credit cards could also be penalized due to their high debt-to-available credit ratio. And people who apply for credit a lot will get dinged just due to the number of credit inquires that are made to their credit file. This is because people that apply a lot probably already have financial pressures causing them to do so.
Read More >>> What is the high cost of a low credit score?
Any negative or derogatory information (that is accurate) in your credit file can remain there for 7 years. Exceptions include bankruptcy (10 years), lawsuits or judgments (7 years or until the statue of limitations runs out, whichever is longer), or criminal records (no time limitation). That is why it is important to review your credit file for inaccurate information and take the necessary steps to correct it (a topic for another article).
To repeat, most all consumer oriented credit scoring models only look at the information contained on your credit report and they do not reflect additional information a lender may consider in its decision to lend or not. For example, your credit report does not include such things as length of employment, career field (do you have a high risk job?), current income or additional sources of income. Some lenders will care about these additional factors while others may not depending on the type and amount of the requested loan.
By law, lending institutions are not allowed to make decisions based on gender, marital status, race, nationality or religion. However, they are allowed to use age as a predictor – only if they can prove their model does not discriminate against the elderly.
Since your credit score is a key tool used by lending institutions, it is important that you retrieve it periodically and make sure it is accurate. If you want to understand your credit scores, get your credit reports and review the data that is being used to calculate them.
So, don’t sweat over the different results. Just note where your score lands in the sub-ranges of the scoring model you are using. And make sure your credit report is accurate!
Skip Lahti is a veteran in the credit reporting and financial planning industry. Now, along with a couple of other reputable industry veterans, he has launched a new website for consumer credit reports and scores that are more accessible and friendly to the average consumer.
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