Credit Scores- How Your Scores Are Calculated

Have you ever been pre-qualified for a credit card, mortgage, or car loan without submitting an application? You may have even been approved online for a loan online within minutes.

What makes this possible is by using your credit scores.

Credit Score Pie Chart

These scores are used by banks; lending institutions, landlords, and even employers use credit scores to help make decisions on their hiring process.

Credit scores became popular in the 1980’s as computers became much cheaper and more commonly used. Before this, lending decisions were arbitrarily made using human judgment. As you can imagine this caused unpredictable and unreliable outcomes, and it could be a time consuming process.

Prior to using credit scoring system there was a growing concern in Congress about discrimination in lending. This led to legislation to remove the human factor when analyzing credit applications.

The first standard rating system was the point rating. This employed a weighted list of credit report items. This did help remove the bias and ambiguity associated with credit ratings. This was shortly replaced by the statistical model which factored in thousands of report items over hundreds of variables associated with the consumer payment histories.

FICO (Fair Isaac Company) was one of the first models developed and soon became the recognized as the predictor of consumer credit behavior. Almost all lending institutions adopted FICO as the de facto standards as the answer to Congressional pressure to address discrimination in the rating system.

This modeling system also provides a clear advantage as well; faster processing, highly predictive; and completely objective.

How does this work??

The basis for credit scoring is Risk Factors. Risk Factors group individuals into risk categories, and ratings are based on relative standing within the group assigned. For example, if someone is placed into the high risk group, that person is rated relative to all other members within the high risk group.

There are also Score Factors. Score factors are the basis for the final credit score. Some items that compromise the Score Factors are; number of credit cards; number of loans outstanding; payment history (i.e. bankruptcies, short-sales, foreclosures, late payments, etc.) debt to income ratio, employment status, and so on.

The range of credit scores is from 300-850. The higher the score reflects a better credit rating. Each of the credit reporting agencies provide a credit score. These creditors are Trans Union, Equifax, and Experian. Each agency has a slightly different model which is why you will see each of them, in most cases, reflecting different scores.

Any score higher than 720-750 is considered outstanding, and anything above that will provide a cushion for any negative items. Below is a guideline for understanding the credit scoring system.

  • 35% from payment history. Your payment history includes collections, late payments, charge offs, judgments, liens, bankruptcies, short-sales, etc.. These items will affect your score negatively, and many will stay on the report for years.
  • 30% reflects your debt distribution (called utilization). Basically, it is best that a number of accounts have low balances than one or two accounts at or near their max limit. Here’s a simple utilization formula: Debt / Credit. The debt to credit ratio should be at or below 10%. As an example, if you have credit card debt of $10 thousand, and your credit limit is $30 thousand, then your ratio is 33% (10 / 30). This is higher than 10%, so you will need to either reduce your debt (payoff the balances) or increase your credit limits.
  • 15% from Established History. The older your accounts are, the better. When a person is first establishing credit, it would clearly help that person to be added to another person’s established account as an Authorized User (usually a family member, such as parents). Established accounts, by definition, have been active (established) for awhile. Being listed as an Authorized User on established accounts will improve a person’s score.
  • 10% Inquiries. Hard (authorized) inquiries of your credit score and report have a slight negative impact on your credit score, but they add up. The more authorized inquiries, the lower your credit scores. Therefore, it is best to keep the number of hard inquiries to a minimum (that is, don’t apply to several banks for a loan at the same time).
  • 10% Mix of Credit. Your score improves when you have various types of loans or debts. This could include revolving credit, auto loan, mortgage loan, installment loans, and so on. Where you can, try to have the balances about the same.

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