Understanding Credit Scoring

Credit scoring is a computerized method for predicting how likely it is that a borrower will repay a loan before it's even issued. Credit scoring allows the process of applying for credit to be automated which saves time for consumers and decreases the likelihood of a mistake.

How Does Credit Scoring Work?

Your credit score is a reflection 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 scores reflect credit patterns over time.

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.

Creditors look for evidence that your monthly payments on non-mortgage debts take no more than 20% of your net monthly income. This is called your debt-to-income ratio. To figure out your debt-to-income ratio, divide your net monthly income by 5.

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:
Payment history
Outstanding debt
How long you have been using credit
Pursuit of new credit
Types of credit in use
FICO is one credit scoring company. Other companies may use different factors.

How Your credit score is calculated

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.

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.

How to improve your credit scores

Raising your credit score, like improving your credit history, takes time and responsible credit behavior. Creditors look for stability in your credit history.

Your credit history shouldn't fluctuate. Stability is key.

Inconsistent behavior such as sudden increases in debts or numerous applications for new credit can lower your credit score.

There are things you can do to make a difference. You can increase your credit score by:
Keeping It Clean
Check your credit report for accuracy. Report any errors immediately.
Pay off all collection accounts. Remember that negative credit information can stay on your credit report for 7 years.
Pay your bills on time. If you missed a payment recently, bring the account current. Don't be late again.
Limiting Yourself
Keep your credit card balances low.
Don't have too many credit cards.
Don't open several new credit accounts just to increase your available credit.
If you're trying to establish credit, don't open too many accounts at once.
Taking It Slow
Pay off debt rather than moving it around from account to account. Your credit history shouldn't look like a seesaw. Stability is key.

Don't close unused credit cards as a short-term strategy to raise your score. Closing an account doesn't make it disappear from your credit report.

Credit scoring, a computerized method for calculating risk, gives creditors a way to predict how well you will manage your debt based on your credit report.

Several factors are considered when calculating a credit score. Various credit scoring companies use different methods and scoring systems.

Know what's on your credit report. Ask your lender for your credit score, and make sure it's explained to you in detail. You can improve your credit score by managing your credit responsibly over time.