Credit Scoring – The Final Test

Whether we like it or not, credit scoring (our report card on our credit) determines what we can buy on credit.

It may be unfair to newcomers who are honest, reliable, and who have not established their creditability, but it is the test!

The best information on credit scoring (in our opinion) was written in an August 1998 article by the Federal Trade Commission called “Credit Scoring”.  This article is informative, but we have updated that with our supplement to it called “The FICO Score”.  Why?  Because the science of credit has developed and now there is an actual credit grading that creditors are using to evaluate your credit and the creditors’ risk.

What follows is the 1998 Federal Trade Commission Credit Scoring article and our article on FICO Scoring.  Finally, we conclude this section with another FTC article called “Choosing and Using Credit Cards”.

We welcome suggestions and ideas on every subject in EasywayUSA, but we would especially welcome ideas of your experiences and ideas on credit, the area which numerous people sfind especially perplexing.

Ever wonder how a creditor decides whether to grant you credit? For years, creditors have been using credit scoring systems to determine if you'd be a good risk for credit cards and auto loans. More recently, credit scoring has been used to help creditors evaluate your ability to repay home mortgage loans. Here's how credit scoring works in helping decide who gets credit -- and why.

What is credit scoring?
Credit scoring is a system creditors use to help determine whether to give you credit.

Information about you and your credit experiences, such as your bill-paying history, the number and type of accounts you have, late payments, collection actions, outstanding debt, and the age of your accounts, is collected from your credit application and your credit report. Using a statistical program, creditors 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. A total number of points -- a credit score -- helps predict how creditworthy you are, that is, how likely it is that you will repay a loan and make the payments when due.

Because your credit report is an important part of many credit scoring systems, it is very important to make sure it's accurate before you submit a credit application. To get copies of your report, contact the three major credit-reporting agencies:

• Equifax: (800) 685-1111
• Experian (formerly TRW): (888) EXPERIAN (397-3742)
• Trans Union: (800) 916-8800

These agencies may charge you up to $8.50 for your credit report.

Why is credit scoring used?
Credit scoring is based on real data and statistics, so it usually is more reliable than subjective or judgmental methods. It treats all applicants objectively. Judgmental methods typically rely on criteria that are not systematically tested and can vary when applied by different individuals.

How is a credit scoring model developed?
To develop a model, a creditor selects a random sample of its customers, or a sample of similar customers if their sample is not large enough, and analyzes it statistically to identify characteristics that relate to creditworthiness. Then, each of these factors is assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its own credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company.

Under the Equal Credit Opportunity Act, a credit scoring system may not use certain characteristics like -- race, sex, marital status, national origin, or religion -- as factors. However, creditors are allowed to use age in properly designed scoring systems. But any scoring system that includes age must give equal treatment to elderly applicants.

What can I do to improve my score?
Credit scoring models are complex and often vary among creditors and for different types of credit. If one factor changes, your score may change -- but improvement generally depends on how that factor relates to other factors considered by the model. Only the creditor can explain what might improve your score under the particular model used to evaluate your credit application.

Nevertheless, scoring models generally evaluate the following types of information in your credit report:

• Have you paid your bills on time? Payment history typically is a significant factor. It is likely that your score will be affected negatively if you have paid bills late, had an account referred to collections, 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.
• How long is your credit history? Generally, models consider the length of your credit track record. An insufficient credit history may have an effect on your score, but that can be offset by other factors, such as timely payments and low balances.
• Have you applied for new credit recently? Many scoring models consider 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 may negatively affect your score. However, not all inquiries are counted. Inquiries by creditors who are monitoring your account or looking at credit reports to make "prescreened" credit offers are not counted.
• How many and what types of credit accounts do you have? Although it is generally good to have established credit accounts, too many credit card accounts may have a negative effect on your score. In addition, many models consider the type of credit accounts you have. For example, under some scoring models, loans from finance companies may negatively affect your credit score.

Scoring models may be based on more than just information in your credit report. For example, the model may consider information from your credit application as well: your job or occupation, length of employment, or whether you own a home.

To improve your credit score under most models, concentrate on paying your bills on time, paying down outstanding balances, and not taking on new debt. It's likely to take some time to improve your score significantly.

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 big enough sample. Remember that these systems generally vary from creditor to creditor.

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 it is properly designed. And many creditors design their systems so that in marginal cases, applicants whose scores are not high enough to pass easily or are low enough to fail absolutely are referred to a credit manager who decides whether the company or lender will extend credit. This may allow for discussion and negotiation between the credit manager and the consumer.

What happens if you are denied credit or don't get the terms you want?
If you are denied credit, the Equal Credit Opportunity Act requires that the creditor give you a notice that tells you the specific reasons your application was rejected or the fact that you have the right to learn the reasons if you ask within 60 days. Indefinite and vague reasons for denial are illegal, so ask the creditor to be specific. Acceptable reasons include: "Your income was low" or "You haven't been employed long enough." Unacceptable reasons include: "You didn't meet our minimum standards" or "You didn't receive enough points on our credit scoring system."

If a creditor says you were denied credit because you are too near your credit limits on your charge cards or you have too many credit card accounts, you may want to reapply after paying down your balances or closing some accounts. Credit scoring systems consider updated information and change over time.

Sometimes you can be denied credit because of information from a credit report. If so, the Fair Credit Reporting Act requires the creditor to give you the name, address and phone number of the credit reporting agency that supplied the information. You should contact that agency to find out what your report said. This information is free if you request it within 60 days of being turned down for credit. The credit reporting agency can tell you what's in your report, but only the creditor can tell you why your application was denied.

If you've been denied credit, or didn't get the rate or credit terms you want, ask the creditor if a credit scoring system was used. If so, ask what characteristics or factors were used in that system, and the best ways to improve your application. If you get credit, ask the creditor whether you are getting the best rate and terms available and, if not, why. If you are not offered the best rate available because of inaccuracies in your credit report, be sure to dispute the inaccurate information in your credit report.

Where can you get more information?

The FTC works for the consumer to prevent fraudulent, deceptive and unfair business practices in the marketplace and to provide information to help consumers spot, stop and avoid them. To file a complaint, or to get free information on any of 150 consumer topics, call toll-free, 1-877-FTC-HELP (1-877-382-4357), or use the online complaint form. The FTC enters Internet, telemarketing, identity theft and other fraud-related complaints into Consumer Sentinel, a secure, online database available to hundreds of civil and criminal law enforcement agencies U.S. and abroad.

August 1998

CREDIT SCORING

The AFICO Score@

The AFICO score@, a somewhat little known, and secret, system of determining your credit rating, will now be available in early summer, 2001, to consumers via the website of Fair, Isaac & Co., of San Rafael, California, who created the score.

The FICO score applies a rating, which ranges from 300 to 900, to each consumer.  Knowing what your score is will be helpful to you in making adjustments to increase your score and in figuring out how to get the best deal on a loan.  Mortgage lenders take into account not only your FICO score, but your income, assets, net worth, and size of down payment.  Some car loans are decided almost entirely on your FICO score.  A score of 700 or higher is regarded as good/excellent, while a score below 600 signals debt problems.  While you may still be able to secure a loan with a lower score, your interest payments are going to be higher.

Credit scoring is used because it is usually more reliable than subjective or judgmental methods.  It treats all applicants objectively and is based on real data and statistics rather than on criteria that are  not systematically tested and that can vary when applied by different individuals.

Under the Equal Credit Opportunity Act, a credit scoring system may not use certain characteristics such as race, sex, marital status, national origin, or religion as factors.  Creditors are allowed to use age, however, but must give equal treatment to elderly applicants.

This is how the scores are calculated:

Payment history is the major factor in determining your score and accounts for 35% of the number.  This is based on whether you have a good history of paying your bills on time.

Debt levels accounts for 30% of your score and includes balances on credit cards, car loans, and student loans.  Keeping these levels generally low, especially on credit cards, is beneficial to your score.  However, also keep in mind that it is better to have a little balance on a line of credit than no balance at all.  Having a small balance demonstrates one=s ability to manage debt.

Credit history accounts for 15% of your score and is based on how long you have had credit.  Hanging on to old credit cards is a good idea.  FICO scores take into account the age of your oldest account and the average age of all your accounts.  By shortening your credit history, you could lower your score.

New debt accounts for 10% of your score.  Every time you apply for credit, the lender pulls a credit report.  Too much jumping around from lender to lender is not favorable in the eyes of someone issuing credit.  A good score would more likely be maintained by keeping established lines of credit.

Credit mix accounts for the last 10% of your score and is based on how much credit you have and the types of debt you have incurred.  Having a credit card from every store in town could be harmful to your score.

Because your credit report is an important part of the credit scoring system, it is very good idea to review your score a couple of times a year to ensure that it is accurate before you submit a credit application.  To get copies of your report, contact the three major credit reporting agencies:

C                Equifax: (800) 685-1111

C                Experian (formerly TRW): (888) 397-3742

C                Trans Union: (800) 916-8800

A score you get through Equifax may differ from your score at Trans Union or Experian.  Using all three scores could be helpful in negotiating a loan.

These agencies may charge you up to $8.00 for your credit report.

To improve your credit score, concentrate on paying your bills on time, paying down outstanding balances, and not taking on new debt.  It is likely to take some time to improve your score significantly.

If you are denied credit, the Equal Credit Opportunity Act requires that the creditor give you a notice stating the specific reasons your application was rejected or that you have the right to learn the reasons if you ask within 60 days.

If you are denied credit because of information from a credit report, the creditor is required to give you the name, address and telephone number of the credit reporting agency that supplied the information, who will then give it to you free of charge as long as it is within 60 days of your being turned down for credit.