What is Credit Scoring?
Credit scoring is a system creditors use to help determine whether to give you credit. Typically a higher number indicates a lower risk.
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. Based on this information, your credit score is generated using a statistical program. However, your score is not physically stored as part of your credit history on the credit file. Rather, it is generated at the time a lender requests your credit report, and is then included as part of the report.
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. The 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. There are many different credit scores used in the financial service industry. Your score may be different from lender to lender depending on the type of credit scoring model that was used.
What are the different types of credit scores?
There are primarily two types of scores: generic bureau-based scores and custom scores. Among bureau-based scores, the most widely used score in the financial service industry is the FICO score generated by the Fair, Issac Company. Each credit bureau can also generate its own credit score, such as the Experian Credit Score. The bureau-based credit scores draw on statistics from a large number of consumers across a variety of accounts. Custom scores are generated by individual lenders, who rely on credit bureaus and other information, such as account history, from their own portfolios. Scores are not just used to rate the credit worthiness of consumers. Lenders also use scores to predict consumer response to offers sent in the mail, the likelihood that account holders will file for bankruptcy or that a consumer will move their account to another lender.
Why are credit scores used?
Before credit scores, lenders physically looked over each applicant's credit report to determine whether to grant credit. A lender might deny credit based on a subjective judgment that a consumer already held too much debt, or had too many recent late payments. Not only was this time consuming, but human judgment was prone to mistakes and bias. Lenders used personal opinion to make a decision about an applicant that may have had little bearing on the applicant's ability to repay debt. Credit scores help lenders assess risk more fairly because they are consistent and objective. Consumers also benefit from this method. No matter who you are as a person, your credit score only reflects your likelihood to repay debt responsibly, based on your past credit history and current credit status.
Who uses credit scores and how are they used?
Banks, credit card companies, auto dealers, retail stores and most other lenders that issue credit or loans use credit scores to quickly summarize a consumer's credit history, saving the need to manually review an applicant's credit report and provide a better, faster risk decision. Although many additional factors are used in determining risk, such as an applicant's income vs. the size of the loan, a credit score is a leading indicator of one's basic creditworthiness.
What information impacts my credit score?
The information that impacts a credit score varies depending on the score being used. Generally, credit scores are affected by elements in your credit report, such as:
- Number and severity of late payments
- Type, number and age of accounts
- Total debt Recent inquiries
Credit bureau-based scores cannot use demographics prohibited under the Equal Credit Opportunity Act, such as race, color, religion, national origin, gender, age, marital status, receipt of public assistance or exercise of rights under Consumer Credit Protection Act. Scores used by individual lenders may use such elements as income, occupation and type of residence in determining their own custom credit score.
How do I improve my credit score?
Paying your bills on time is the single most important contributor to a good credit score. Even if the debt you owe is a small amount, it is crucial that you make payments on time. In addition, you should minimize outstanding debt; avoid overextending yourself and applying for credit needlessly. Applications for credit show up as inquiries on your credit report, indicating to lenders that you may be taking on new debt. Use the credit you already have to prove your ongoing ability to manage credit responsibility. If you do have negative information on your credit report, such as late payments , a bankruptcy , public record item or too many inquiries , your best strategy is to pay your bills and wait. Time is often your best ally in improving credit.
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 -- Know Your Credit Rating. To get copies of your report, contact the three major credit reporting agencies: Equifax, Experian, and Trans Union.
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