How Credit Scoring Works

    Have you ever wondered how credit scoring works? Credit scoring uses statistical math to assess a loan applicant’s risk, resulting in a number that scores the likelihood that the applicant will repay the loan in full.

    The numbers work more like bowling and less like golf. The higher the number, the better candidate the applicant is to repay the debt, because their risk is low. The lower the number, the higher the risk, which means the applicant is less likely to repay the loan.

    The most used score is a FICO score, which was created by Fair Isaac & Company. This score is used by the three major companies, Experian, Equifax, and TransUnion. Credit agencies use different algorithms to calculate a credit score, based on positive and negative information in your credit report.

    Delinquent accounts in the past or present, debt level, the length of time you’ve had credit, types of credit, and the number of credit checks you’ve had all figure into your credit score.

    Credit bureaus do not consider demographic values such as race, gender, or marital status, nor do they consider your income, the balance of your savings account, or down payments into your score.

    In other words, if you’re of Russian, Guatemalan, or Ugandan descent won’t make a difference in your credit score, nor will it make a difference if you are the CEO of Google or the pixie dust spreader on the Tilt-a-Whirl. However, making late payments on your VISA card will lower your score, while re-establishing a record of on-time payments on your debt will raise it.

    Different aspects of your credit file have different weight in calculating your score.

    35% –   Past credit performance – such as late payments, collections, judgments, bankruptcies.

    30% – Present indebtedness.

    15% – Length of time credit has been in use.

    10% – Types of credit – installment loans, revolving credit, etc.

    10% – Pursuit of new credit – How many inquiries you have on your credit.

     

    The biggest factor for a good credit score is paying your bills on time. Instead of moving debt around, pay it off. Pay all of your bills on time.

    Some have said to close unused credit cards to quickly raise your score. This may actually be detrimental to your goal. Owing the same amount on fewer cards can lower your score. The best thing to do is to pay your bills on time and pay down your debt.

    Each score has up to four reason codes. These are the biggest reasons why your credit score is what it is.

    In order for you to actually have a credit score, you need… wait for it… credit. That’s right. You have to have credit for a score. You need at least one account that has been open for more than six months. You also need one account to have been updated in the past six months to get a score.

    There are a few entities who can access your credit file, based on the Fair Credit Reporting Act (FCRA). Companies who grant credit, collection agencies, insurance companies, and employers can access your credit file, but they must have a “permissible purpose” and a “legitimate business need.” If they do look at your credit file, they will show up as an inquiry. Only inquiries you request actually show up for the basis of your credit score. The local car dealer and the multiple credit card applications that fill up your mailbox with “You’ve Been Pre-Approved” notices are logged as “promotional” and don’t impact your score, since you didn’t request them.

    Otherwise, no one else can look at your credit files. Even your mom can’t have access.

    Some people wonder about the negative impact from rate shopping for a mortgage. In order to get an accurate mortgage rate from a lender, you have to submit to a credit check, which is an inquiry. Some worry about the fact that too many inquiries can ding your credit.

    Recent changes, however, minimize that negative impact from rate shopping. If you request a lender to inquire on your report within the past year (from mortgage or auto lenders), those inquiries are ignored for the first 30 days for scoring purposes. Then, for the next two weeks, multiple inquiries are counted as one. All inquiries show up on the credit report, but are not counted as multiple inquiries for the computation of your score.

    And that… is how credit scoring works.

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