If you have applied for a loan lately, you have probably heard about your
credit score. You certainly heard about it if your loan request was denied - 'Hey Mr. Jones, do you really expect me to finance a Humvee for someone with a credit score of 490?' You probably heard about it if your score was spectacular - 'Wow, 830! Are you sure you wouldn't like to buy two houses?' However, if you fell somewhere in the middle, you might not realize the impact that this technology-based underwriting wrinkle may have had on the quality of your loan.
Credit scoring is not new, it has been showing up in some form on credit reports for a number of years, but it has been raised to an art form by a company called
FairIsaac Corporation or
FICO. FICO developed the software as well as many ancillary products, aimed at both lenders and consumers, that compute credit scores and offer advice on interpreting or improving them.
Credit scores are only part of the information that lenders look at when making a lending decision and a low score is not necessarily a fatal blow. Each lender has its own strategy and level of risk and each has its own cut-off point below which it will not extend credit at any price. But knowing the hows and whys of credit scoring is essential to anyone thinking about a purchase money mortgage, a refinance, or a home equity loan in the near future.
There are other companies other than FICO which score and report on credit, but FICO's is the most popular method (although each of the credit bureaus have their own proprietary name for the FICO product) and most lenders refer to it as a FICO score. Therefore, we will use that term. Most of the information on credit scoring that follows was provided by them or by The Bureau of Consumer Protection, Federal Trade Commission.
Lenders typically buy credit reports from one or more of three national credit reporting companies;
Equifax, Experian,
and TransUnion. More and more, however, lenders are also buying FICO scores produced by these companies. These scores are a mathematical evaluation computed from information about an individual borrower already on file with that credit bureau which is compared with patterns distilled from hundreds of thousands of other credit reports.
While FICO does not divulge its methods (trade secrets and all of that) we presume that historical credit data on large numbers of individuals are grouped into credit score groups or cohorts and tracked to evaluate ongoing credit performance. If, from a group of credit subjects with a FICO score of 550 in 1994, 60% ultimately had a car repossessed while 40 percent subsequently managed to pay off large loads of credit card debt, that cohort's scores would be weighted to reflect those statistics. This weighted number, supposedly, allows lenders to predict the risk inherent in lending to others with that score. The higher the score, the lower the risk.
According to FICO, all information in their scores come straight off of an individual's credit report. Since information on file may vary from one credit bureau to another, it is very common for an individual to have three different (although usually not wildly divergent) credit scores. Collected information is weighted by FICO software in approximately the following ratios:
Payment History ' 35%:
Have payments been made in a timely manner? Is there a consistent history of slow payments? Have there been charge-offs, collection activity, occurrences of foreclosure, bankruptcy, suits, liens, or repossessions?
Amounts Owed ' 30%:
What is the total debt, debt on individual accounts, number of accounts, percent of available credit converted to debt? If credit lines or cards are exhausted, this will have a negative impact on a credit score.
Length of Credit History ' 15%:
How long has the borrower been a creditor? An insufficient credit history or lack of credit history will have a negative impact on a credit score. FICO, in fact, will not calculate a credit score unless a credit report shows an account which has been open for six months or more and at least one account that has been updated in the previous six months.
New Credit ' 10%
The number of recently opened credit accounts and their proportion to total open accounts and/or the number of recent credit inquiries may be viewed as an indication of cash flow problems. However, new credit, if indicating re-establishment of a positive credit history following credit problems will have a positive impact. (Certain inquiries such as those put through by companies seeking customers for 'pre-approved' credit card offers or those by existing creditors monitoring existing customers credit performance are not considered in the credit score.)
Types of Credit Used ' 10%
Too many credit card accounts, revolving retail charge accounts, or loans from certain types of lenders such as finance companies can have a negative effect on scores.
These are guidelines for the general population. Evaluation criteria for persons, for example with newly established credit, may be different.
Lenders may also integrate information from your loan application, such as your job, length of employment, or whether you own a home.
Certain types of information are not used in compiling a credit score. U.S. law prohibits race, color, religion, national origin, sex and marital status from being used in any type of credit evaluation including scoring. Age is not a factor in constructing a FICO score but may be used in other kinds of credit scoring. Other information such as location of residency, interest rates on current loan obligations, and child or family support obligations may be used in some credit scoring programs but are not factors in a FICO score.
FICO scores range from around 300 to about 850. Approximately 1 percent of the population with established credit has credit scores below 500 and another 13 percent score from 500 to 600. By far the largest group, 28 percent, is in the 750 to 799 scoring range. About 11 percent of the population is in that rarified area above 800 points. The median credit score (the point where 50 percent rank higher and 50 percent rank lower) is 723. Americans obviously care about and take care of their credit.
As stated earlier, a bad FICO is not necessarily the end of the road, but it will affect your loan. Soon we will take a look at how interest rates and other loan features can be impacted by credit scores and suggest some ways to improve those scores.