How is it possible to get pre-qualified for a car loan without discussing your salary? Or to be approved for a mortgage at an interest rate that differs from your neighbors? Or get a personal loan online within a few minutes?
All this is possible with the use of credit scores.
Banks, financial institutions, landlords, and even your employer rely on your credit score to make decisions about financing, tenancy, and employment every day.
Credit scores came into wide use in the 1980s as computer costs dropped and their use exploded in business. Prior to this, lending decisions were based on human judgment which was both unpredictable and unreliable, in addition to being slow.
During this period, there was growing Congressional action arising from discrimination in housing that put pressure on institutions to remove the ambiguity and bias from the rating system. Legislation was passed in 1971 (FCRA) and again in 1977 (FDCPA) which forced Credit Rating Agencies (CRAs) to revise their rating procedures.
Initially a standard point system was developed that weighed various items on the credit report. This approach reduced human bias and sped the evaluation process. Eventually the point system was replaced by statistical modeling of thousands of reports covering numerous variables that focus on consumer payment histories. Considered a much better predictor of consumer credit behavior, all banks and financial institutions now rely on it. The obvious advantages are: more accurate predictor; extremely fast; highly objective; and very efficient.
Fair Isaac Company led the way with the first statistical model that quickly became the standard in the industry, called FICO. This was the industry's answer to Congressional legislation outlawing discrimination in the rating process.
How does it work?
Credit scores rely on Risk Factors. If you are placed in a high risk category, then your score will be relative to others in the same category. If you have a limited credit history, then you will be compared to others with similar credit histories.
Entries to your credit report are grouped into Score Factors which are used to calculate your score. A partial list of items that factored in are: number of loan and credit card accounts; total debt to income; payment history including late payments, foreclosures, bankruptcies, employment status, etc .. When declined credit, the bank must mention the specific score factors that resulted in the decision
Credit scores range from 300 to 850. The higher the score, the better your credit rating. There are three major credit bureaus (or reporting agencies): Equifax, Experian, and TransUnion. Since each has its own version of the FICO model, you literally have three credit scores. Typically, the banks will take the two highest or two lowest scores (depending on bank policy) into account when evaluating loan applications.
Any score above 720 to 750 is considered excellent, and anything above that is just providing a cushion.
A general guideline for scoring from your credit report is a follows:
• 35% from payment history. If you have any late payments, collections, charge offs, foreclosures, short-sales, bankruptcies, judgments, liens, etc., this will reduce your score. These are called negative entries to you credit report.
• 30% is based on utilization, or how your debt is distributed. For example, it is better to have several accounts with low balances than one or two accounts that are maxed out. A simple utilization formula is: Current debt / Credit limit. The lower that ratio, the better. Try to stay below 10%. For example, if your credit limit on your credit card is $ 20 thousand, and your current debt outstanding on the card is $ 5 thousand, then your ratio is 25% (5/20) which is too high. Either raise your credit limit, or reduce your debt.
• 15% from Established History. That is, the older your active accounts, the better. When first establishing credit, it would be helpful if you could be added as an Authorized User on another persons established account (generally done within the family, such as parents). This will enable you to acquire accounts that have been active for awhile, thus boosting your score.
• 10% Inquiries. The more inquiries regarding your credit report and score, the lower your score becomes. Therefore, try to keep the number of authorized inquiries to a minimum
• 10% Mix of Credit. Here it is good to use different forms of credit: revolving credit, installment loans, mortgage, auto, etc. Try to keep an equal balance amongst the differing forms of credit.