Credit Scoring: What and How it Works

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 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 gives points for each factor that shows that you are likely to repay a debt. The total number of points computed is known as your credit score (or FICO score) and helps predict how likely it is that you will repay a loan and make the payments when due. Because your credit report is an important component of many credit scoring systems, it is very important to make sure the information it contains is accurate before you submit a credit application. To get copies of your report, contact one of 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 a fee for your credit report. What is "A" Credit? While factors vary, typically individuals with FICO scores above approximately 620 are deemed to be "A" credit borrowers. Generally speaking, the higher your credit score, the greater your likelihood of being approved for the loan you want. Potential borrowers with FICO scores below 620 can often still qualify for a mortgage, but the product might not have the best rate or might have other less-favorable features. What is my score based on and what can I do to improve my score? Scoring models generally evaluate the following types of information in your credit report: Payment History (35%) Payment history is typically 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. Note that closing an account on which you had previously missed a payment or satisfying a judgment or collection item does not make the late payment disappear from your credit report. Amounts Owed (30%) Many scoring models evaluate the amount of debt you owe compared to the limits on your accounts. If the amount you owe is close to your credit limit, it is likely to have a negative effect on your score. The amount of accounts that have balances is also taken into consideration. A large number of accounts with balances can indicate higher risk of over-extension. Length of Credit History (15%) Generally, models consider how long you have had credit history. A longer credit history will increase your score, however even people who have not been using credit long can get high scores if they have made their payments on time and do not carry large balances. New Credit (10%) 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 recently applied for too many new accounts, your score will most likely be negatively affected, 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. Types of Credit (10%) 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 is likely that it will take some time to improve your score significantly.