The FACT Act defines a credit score as “A numerical value or a categorization derived from a statistical tool or modeling system used by a person who makes or arranges a loan to predict the likelihood of certain credit behaviors, including default.” In other words, a credit score is a grading system that adds or subtracts points based on data found in a credit report. Negative factors include late payments, maxed out credit cards, and bankruptcies, while positive factors include older accounts and regular timely payment histories. Credit scores are used by companies to make decisions such as whether to approve a mortgage, issue a credit card, rent an apartment or offer someone a job.
Back in 1956, Bill Fair and Earl Isaac came up with the idea of using predictive models to predetermine credit risk. After initially being dismissed by the financial service community, the model proved effective and was adopted. You will recognize them as the Fair Isaac Corporation (FICO) and they have dominated the scoring business for years.
The three national credit bureaus mentioned earlier have all “rented” space on their computers to Fair Isaac and can produce a score upon request. As stated earlier, scores are relayed as a numeric value. Different lenders use different scoring formulas, so your score can vary from lender to lender. Usually a higher score makes it easier to qualify for a loan and means a better rate of interest. Most scores range from 300-850, although there is one scoring method that uses a range from 501-990. FICO scores range from 300 – 850. Individuals with a credit score of 620 or lower are considered a poor credit risk, while scores of 720 or higher are a good credit risk.
In March 2006 the three national credit bureaus announced a joint venture and a new credit scoring system called VantageScore. This credit scoring system was developed to directly compete with FICO. Also, the bureaus would now apply a uniform scoring model.
The exact formula of that FICO, VantageScore and other scoring models use is a trade secret. However, both Fair Isaac and VantageScore have provided some guidance on the factors used and the importance each is given when scores are calculated.
The factors that comprise the FICO score and the relative weight assigned to each factor are:
- Payment history – 35%
- Amounts owed – 30%
- Length of credit history – 15%
- New credit – 10%
- Types of credit used – 10%
The factors that comprise the VantageScore and the relative weight assigned to each factor are:
- Recent credit – 30%
- Available credit – 1%
- Payment history – 28%
- Utilization – 23%
- Balances – 9%
- Age and Type of Credit – 9%
Regardless of the scoring model used, individuals need to understand that what comprises of the score comes directly from what is in their credit reports. If the information is inaccurate in the report, then this will be reflected in the score. The converse is also true, if the information is correct it will be reflected in their score.
Individuals should know how to improve their credit score or what actions they will take will impact it. The following list are some actions that will both help and hinder.
Most scoring models look at an individual’s payment history. The more experience they have, preferably with on time payment, the better. Greater weight is given to more recent history, so if someone has had difficulty, they can remedy this by getting back on track.
Most scoring models look at how close an individual is to being at the maximum balance on revolving lines of credit, such as credit cards. This is where you need to be aware of what impact closing unused credit cards can have on a score. If someone closes credit card accounts and put consolidates most or all of their credit card balances onto one card, it may lower their credit score because it will show that they are using a high percentage of their total credit limit or high utilization which reflects higher risk. To avoid this that same individual could consolidate their balances onto the one card, but not close the other accounts. They would show an available (but perhaps unused) balance and thus lower utilization. It is thought that individuals should try and stay below a 30 percent utilization of total available revolving credit.
Credit scoring models look at an individual’s recent credit activity as an indicator of their need for credit. If there has been a lot of activity in a short period of time this raises a red flag to creditors that an individual may be experiencing some financial difficulty.
The Fair and Accurate Credit Transactions Act (FACT Act) entitles all consumers to receive one free credit report annually from each of the three national credit bureaus. The free credit reports provided by credit bureaus do not include credit scores. These bureaus charge a fee for providing this information.
Currently a consumer is entitled to receive a copy of their credit score if a creditor used it, in whole or in part, on their credit report to:
- deny their application,
- increase the cost of their credit, or
- offer them a higher rate than other consumers would have gotten from that creditor (when the offer has more than one interest rate).