Have you ever wondered how creditors decide whether to grant you credit?  Credit reporting agencies (CRAs) have been using complex computer scoring models for many years to determine creditworthiness of borrowers.  Credit scoring models award points for various factors, such as prompt payments and low balances.  They also deduct points for derogatory activities, such as late payments and collections.  These factors, in turn, help predict who is most likely to repay a debt and who is most likely to default on a given loan.  Credit scoring helps mortgage lenders evaluate your ability to repay mortgage loans.  Here is a brief explanation of how credit scoring works for you ... and against you.

1. What exactly is credit scoring?

2. Why is credit scoring used?

3. How are credit scoring models developed?

4. What can I do to improve my score?

5. How reliable is the credit scoring system?

6. What if I'm denied credit or don't get the terms I want?

7. Credit scoring facts and fallacies

8. What's the score?

9. Risky Business

10. What your credit score DOES NOT contain

1. What exactly is credit scoring?

Credit scoring is a system that creditors use to help determine whether they can grant you credit.  Information about you and your credit experience is collected from a variety of sources, including existing creditors and kept in credit reporting agency data repositories.

Your credit profile details your bill-paying history, your credit limits, your outstanding debt, the numbers and specific types of accounts you may have, late payments, public filings (e.g., judgments and bankruptcies), collection activity, the age of your accounts, among other things.

Credit reporting agencies compare this information to the credit performance of consumers with similar profiles. A credit scoring system awards points for each factor that helps predict who is most likely to repay a debt. The total number of points (credit score) can be used as a measure of your creditworthiness, that is, how likely it is that you will repay a loan and make the payments when they are due.

Because your credit report is an important part of many credit scoring systems, it is very important to make certain that it is accurate before you submit your next credit application.

2. Why is credit scoring used?

Credit scoring is based on objective historical and statistical data, so that it is far more reliable than subjective or judgmental methods.  Judgmental methods rely on criteria that are not systematically tested and can vary widely when applied by different individuals and organizations.  Objective models based on statistical and historical data are acceptable by the broadest array of lenders and creditors.

3. How are credit scoring models developed?

A creditor selects a random sample of its customer base, or a sample of similar customers, and analyzes the data statistically.  This identifies characteristics that relate to the creditworthiness of the customers in the sample.

Each of the factors in the sample is assigned a weighted value based on how strong a predictor it may be.  This determines creditworthiness.  Each creditor may use its own credit scoring model or a different scoring model for different types of credit.  Generic models are developed by the credit scoring company.

Under the Equal Credit Opportunity Act, a credit scoring system must not use certain characteristics as factors for consideration  (e.g., race, sex, marital status, national origin, or religion).  However, creditors are allowed to use age in properly designed scoring systems, but only in determining whether the applicant is able to enter into contracts.  Any scoring system that includes age as a factor must give equal treatment to elderly applicants.

4. What can I do to improve my score?

Credit scoring models are complex algorithms which vary across all credit reporting agencies and by different types of credit obtained.  If one factor changes, your score changes -- but improvement generally depends on how that factor relates to other factors considered under the scoring model.  Only the various credit reporting agencies can explain your score under the their particular scoring model.

To improve your credit score, concentrate on paying your bills in a timely manner, reducing outstanding credit balances, and not taking on any additional debt.  Over time, even the most derogatory items in your credit history will be out-weighed by your most recent payment habits.

The following information applies to scoring models and are factors used to determine your score:

• Do you pay your bills on time?
  Payment history is a significant factor. Your scores will be affected negatively if you have paid any bills late that report to one or more credit reporting agencies, of if you have had an account referred to collection that also is reported.  Collectors often , or declared bankruptcy, if that history is reflected on your credit report.
  
  

• What is your outstanding debt?
  Many scoring models evaluate the amount of debt you have compared to your credit limits. If the amount you owe is close to your credit limit, that is likely to have a negative effect on your score. To optimize the benefits of revolving credit tradelines, always maintain credit card balances below 50% of their credit limits.
  
  

• How deep (long) is your credit history?
  Generally, models consider the length of your credit track record.  An insufficient credit history will often have an effect on your score.  A shallow history can be offset by other factors, such as timely payments and low outstanding credit balances.
  
  

• Have you applied for new credit recently?
  Credit scoring models consider the number of recent inquiries as a "bad" thing for two reasons.  One is that a large number of inquiries may indicate that a whether you have applied for credit recently by looking at "inquiries" on your credit report when you apply for credit.  If you have applied for too many new accounts recently, that will negatively impact your score.  However, not all inquiries are counted. Inquiries that you make, those used to monitor your credit, and those made by credit guarantors who desire to make "prescreened" credit offers are not counted against you.
  
  

• How many and what types of credit accounts do you have?
  Although it is generally good to have established revolving credit accounts, too many credit card accounts may have a negative effect on your score, especially when the unpaid balances are high. In addition, scoring models consider the type of credit accounts that you have.  Loans from finance companies, for example, will be considered as "high risk" and will adversely impact your credit score.  If you pay only the minimum payment on a negative amortization loan, allowing the loan balance to grow, your credit scores will plummet when the creditor reports the differed interest (causing your current balance to exceed your original credit limit).
  
  

• Some scoring models consider more than just information in your credit report.
  Credit scoring models may consider information from your credit application such as the type of credit for which you applied in addition to the rest of your history.  Your job or occupation, length of employment, whether you own a home or rent, and the length of time at your most recent residence are also taken into consideration.  Accumulated assets (e.g., bank accounts, 401(k) balances, pensions, etc.) are an additional consideration when applying for a mortgage loan.

5. How reliable is the credit scoring system?

Credit scoring systems enable creditors to evaluate millions of applicants consistently and impartially on many different characteristics.  But to be statistically valid, credit scoring systems must be based on a large enough sample. Please remember that these systems generally vary from one creditor to another.

Although you may think such a system is arbitrary or impersonal, it can help make decisions faster, more accurately, and more impartially than individuals when the scoring model is properly designed.

Many creditors design their systems so that in marginal cases, applicants whose scores are not sufficiently high to easily pass muster or may be low enough to fail absolutely, are often referred to a credit manager who decides whether the creditor or lender will extend credit. This may allow for discussion and negotiation between the credit manager and the consumer or their representative.  In the mortgage lending industry, however, very few exceptions are granted if your mid-score falls even one point below a particular credit grade or otherwise falls outside specific underwriting guidelines!

FALLACY:  Credit scoring is unfair to minorities.

FACT:  Nothing could be further from the truth!  Credit scoring takes into consideration your payment history, debt load, public records, inquiries, and the types of credit -- only credit-related information.  Factors such as gender, race, nationality, and marital status are not included.  In fact, the Equal Credit Opportunity Act (ECOA) strictly prohibits lenders from considering anything beyond credit-related information when issuing a loan or credit.

Independent research has been conducted to assure that credit scoring is never unfair to minorities and individuals with shallow credit histories.  Credit scoring has proven to be an accurate and consistent measure of repayment.  In other words, at any given score, non-minority and minority applicants are equally prone to pay as agreed.  Credit scoring only discriminates against those who fail to honor their commitments, regardless of skin color or ethnic origins.

FALLACY:  Computers make all the lending decisions.

FACT:  Computers do not make lending decisions.  Humans do.  Computers merely analyze credit information (as reported by your creditors) in order to produce a credit score.  Individual lenders decide what scores are acceptable for each loan scenario, based upon established underwriting criteria.  Some lenders will accept high risk applicants (at inferior loan terms), while others will not.  In fact, some lenders may grant a score exception during the underwriting process if compensating factors warrant it (compensating factors may include job stability, significant net worth, equity in the property on which the loan is to be placed, etc.).

FALLACY:  A poor credit score haunts you "forever".

FACT:  That really depends on your motivation of the individual in question.  Your scores are simply "snapshots" of your risk at a particular point in time.  Scores change from day to day as new information is added to your credit profile.  Scores will gradually improve as you improve the manner in which you handle your payments and as your credit history grows.  Past credit problems have less influence on your current score as time passes.  Lenders request your current score when you submit a loan application, so they know how you measure up today, not based upon the financial indiscretions of your youth.  Furthermore, if you remove inaccurate information in your credit profile, your score will also improve more quickly.

FALLACY:  Credit scoring infringes on my privacy.

FACT:  A credit score represents a summary of information that credit guarantors, lenders, banks, agencies of government, and others (including yourself) have placed in public or private records.  Various credit repositories maintain these records.  We like to think of your credit history as the adult version of the "permanent record" that you may have worried about in grammar school.

FALLACY:  My score will drop whenever I apply for new credit.

FACT:  Yes, but usually not by much, and only when you are cautious.  When you apply for several credit accounts or loans within a brief period, inquiries will appear on your report.  Excessive shopping for new credit may be equated with higher risk or an act of desperation.  Only then will it adversely impact your credit scores.

Credit scoring algorithms handle inquiries differently, based upon your current creditworthiness.  If you have good credit, you may be "immunized" to a degree against multiple inquiries, and your score is not likely to drop much.  If you have poor credit, on the other hand, multiple inquiries will be perceived as the actions of a desperate person, and your score may drop precipitously.

Major credit reporting agencies will lead you to believe that there is a small "window" during which credit pulls for vehicle loans may be made with relative impunity.  THIS IS GROSSLY MISLEADING!  In fact, lofty organizations such as the Mortgage Bankers Association has been perpetuating this myth!  (We even bought into this B.S. until we performed a study of credit inquiries as they relate to auto loans.)

When several car dealers each submit your loan request to an automated system such as DealerTrack, your credit will be pulled dozens of times as the loan is being scrutinized by dozens of different lenders.  This number is then multiplied by the number of dealers you may have authorized to pull credit.  Under such circumstances, your credit score could take a very serious pounding!

A good rule of thumb is to NEVER shop for a vehicle or other big-ticket item prior to taking out a mortgage.  If you do, it could cost you tens of thousands of dollars in interest on your new mortgage.  Always buy your "toys" AFTER you purchase or refinance your home!

When you shop for a mortgage, it is wisest to pick a single broker that you can trust.  Even when the borrower is well-qualified and the loan appears straightforward, it may be necessary to present the loan to several lenders to obtain the best possible interest rate and terms.  Most experienced brokers can shop your loan to dozens of lending institutions using a single copy of your credit report (which must be pulled in the broker's name).  Rate shopping from one broker to another is foolhardy and will ultimately result in your credit being pulled over and over.  If you have the misfortune of working with an inexperienced broker, they could inadvertently re-pull your credit many times.  The risk there is that they may ultimately disqualify you for the best possible loan, in which case you may be tempted to continue shopping and further damage your credit scores.

WARNING:  Never mistake an internet website that claims to submit your loan to several lenders as anything more than a "lead generator".  Lead generators sell your private information to many lenders as a method of generating revenue.  Did you really think they were a FREE service?  Not only will you receive dozens, if not hundreds, of telephone calls, and you may run the risk of having your credit pulled countless times.  These same morons also pester legitimate mortgage brokers with offers to provide "fresh leads" (for a price) that, in reality, may be months old.  Nothing is more frustrating to an honest broker than to contact one of these "hot" leads, only to find out that the potential customer has been called 30 or 40 times that day -- or that the customer had already received a loan three months ago.  The same can be said of real estate lead generating websites.

Credit scores are generated from many different credit data in your consumer credit profile. These data can be grouped into five categories, as indicated in the graphic below. The percentages in the chart reflect the relative importance of each of the categories in determining your score.

 

These percentages are based on the importance of the five categories for the general population. For particular groups, such as those who do not have a lengthy credit history, the importance of these categories may be evaluated differently.  Examples of how these various factors influence a person's credit score are indicated below.  These are your risk predictors.

Payment History (35%) - What is your track record?

• Account payment information on specific types of accounts (e.g., credit cards, installment loans, equity lines, finance company accounts, mortgages, etc.)

• Presence of adverse public records (e.g., bankruptcies, judgments, liens, garnishments, lawsuits, etc.), collection items, or delinquency (past due items)

• Severity of delinquency (how long has it been past due)

• Total amount past due on delinquent accounts or collection items

• Time since most recent delinquencies (if any), adverse public records (if any), or collection items (if any)

• Number of past due items on file (if any)

• Number of accounts paid as agreed

Amounts Owed (30%) -- How much is too much?

• Balance owing on credit accounts (e.g., big balances with short histories lower your scores)

• Amount owing on specific types of accounts (e.g., high risk loans from finance companies lower scores)

• Number of accounts with balances (e.g., many accounts with high balances will decrease your scores)

• Lack of a specific type of balance (e.g., negative amortization loans with increasing loan balances will hammer your scores)

• Proportion of installment loan amounts still owing (e.g., proportion of balances to original loan amounts on certain types of installment loans may influence your scores )

• Proportion of credit lines used (e.g., proportion of balances to total credit limits on specific types of revolving accounts can influence your scores)

Length of Credit History (15%) -- How well-established are you?

• Time since accounts first opened (e.g., long credit histories help raise your scores)

• Time since last account activity (e.g., inactive tradelines do not raise or lower scores)

• Time since accounts opened by specific type of account (e.g., high-risk loans lower your scores)

New Credit (10%) -- Are you biting off more than you can chew?

• Number of recently opened accounts, and proportion of accounts that are recently opened (by type of account)

• Number of recent credit inquiries (e.g., too many inquiries may lower your scores)

• Time since recent account opening, by type of account (e.g., recent addition of several accounts will drop your scores temporarily.  How much is dependent on the type of account opened.)

• Time since credit inquiries (e.g., many recent inquiries could indicate "desperation" and scores will suffer)

• Re-establishment of positive credit history following past payment problems (e.g., solid new tradeline histories will improve your scores)

Types of Credit Used (10%) -- Is your credit a "healthy" mixture?

• Number of (presence, prevalence, and recent information on) various types of accounts (e.g., revolving credit cards, installment loans, mortgages, equity lines, retail accounts, consumer finance accounts, etc.)

NOTE:

• Your credit scores take into consideration ALL categories of information, not simply one or two.
  No one piece of information alone determines your score.  Scores are an amalgam of all categories.

• The importance of any one factor depends on the overall information in your credit report.
  A given factor may be more important than another for someone with a different credit history than your own. As the information in your credit report changes, so does the importance of each factor in determining your score. As such, it is virtually impossible to predict exactly how important any single factor is in determining your score.  The levels of importance shown here are for the general population.  What is most important is the mixture of collected information, which will vary widely from one person to another, and for any one individual over longer periods of time.

• Your credit score looks only at the information contained in your credit report.
  However, most lenders will look at many factors other than those contained within your credit profile when making a credit decision.  These factors include your income, your time at your current job, your time at your current residence, your accumulated assets, and the type of credit requested.

• Your credit score considers both positive and negative information in your credit report.
  Delinquencies will lower your credit score, but establishing (or re-establishing) a solid track record of timely payments will improve your credit score.

 

Credit scores consider a wide range of information, but they do not take into consideration any of the following criteria:

• Your race, color, religion, national origin, sex, and marital status
  Federal law strictly prohibits credit scoring from considering any of these these facts.

• Your age
  Credit scoring may not take your age into consideration.  However, real estate law and mortgage qualification may only consider your age if you are to young to execute a binding contract.

•  Receipt of public assistance
  Any form of public assistance or Social Security cannot be taken into consideration.

• Your occupation, title, employer, salary, date of employment, or employment history.
  Mortgage lenders are likely to consider this information, however.

• Where you chose to live
  This should have no bearing on your creditworthiness.  Many lenders are likely to be more comfortable with someone who has remained in their present residence for the past two years, however. 

• Interest rates being charged on a particular tradeline
  Although specific types of accounts (e.g., high-risk consumer finance company loans) may influence the credit decisions of many lenders, interest rates are not indicated.

• Any items reported as child/family support obligations or rental agreements.
  Child support, alimony, separate maintenance, and rental agreements are not reported -- UNLESS -- they go into collection.  As long as a payment schedule has been established to cure any arrearage, delinquent child support payments are an acceptable risk to some lenders as long as they do not place debt-to-income ratios above acceptable levels.

• Certain types of credit inquiries
  Your credit score does not count "consumer-initiated" inquiries (e.g., requests that you have made). Your scores do not count "promotional inquiries" (e.g., requests made by lenders in order to make you a "pre-approved" credit offer) nor do they count "administrative inquiries" (e.g., requests made by lenders to review your account). Requests indicated as employment-related are not counted either.

• Information that is not proven to be predictive of future credit performance
  If a lender cannot prove that a particular piece of information is indicative of a known risk pattern, the information cannot be used to influence your scores.

• Whether or not you are participating in consumer credit counseling or debt counseling
  As long as the counseling does not specifically brand the accounts that it manages, there is no harm.  However, Consumer Credit Counseling Services are usually reported on any tradelines that are included or settled. Whenever "settled for less than full amount" is indicated, lenders may use this information to deny a loan or extension of credit, or adjust the interest rate or terms to reflect an additional layer of risk.  So effectively, consumer credit counseling is most often considered by many lender to be the same as a Chapter 13 bankruptcy, for all intents and purposes.

• Any information not found in your credit profile
  This should be painfully obvious.  What no one can see cannot hurt you.  If a piece of information is not contained in your profile, it ought not be used against you.  Thus, any unrecorded debts, liens, obligations, loan guaranties, bonds, etc. cannot be used to disqualify you from obtaining a loan.  Having said that, however, you do have a moral obligation to disclose such information to a potential credit guarantor.