Did you ever wonder how it is you can go online and be approved for credit within 30 seconds?
How about getting pre-qualified for a car without anyone asking about your income?
Why do you get one interest rate on loans while your neighbor gets another?
The answer is your credit score.
Your credit score is a mathematical number that is generated by a mathematical formula based on the information provided in your credit report. Compared to the information of millions of other people. The resulting number is a prediction of how you will pay your bills. Thus making the accuracy of the information contained in each of your credit reports extremely important.
Credit scores are used extensively and if you have ever gotten a loan for a car, mortgage or even a credit card, the rate that you received was in relation to your credit score. The higher the score, the lower the interest rate. Lenders use a variety of different models to determine your credit worthiness but the most common is the FICO score developed by the Fair Isaac Company. Their scale runs from 300 to 850. The average consumer will score between 600 and 800.
Fair Isaac reports that the American public’s credit scores break down as follows:
499 and below 2%
500 to 549 5%
550 to 599 – 8%
600 to 649 12%
650 to 699 15%
700 to 749 18%
750 to 799 27%
800+ – 13%
The exact formula for determining the score seems to be a closely guarded secret, with only vague explanations on how the score is calculated. To make matters even more confusing, each of the three major credit bureaus has their own version of the FICO scoring method. Equifax has the BEACON score, Experian has the Experian/Fair Isaac Model and TransUnion has the EMPIRICA score, each using different formulas.
But there does seem to be some ray of hope on the horizon because the credit bureaus collaborated on a standardized scoring model called the Vantage Score. The score range is between 501 and 990 with a corresponding letter grade, A through F, with a school-like grade of A being the best. But until this scoring model catches on, consumers will continually be confused.
No matter which type of scoring method is used, it is vitally important to have the best credit score possible. The better the score, the better he interest rate. According to Fair Isaac’s website, a score of 520 will receive an interest rate 4.36 percent higher than a consumer with a score of 720.
To put this in perspective, a $100,000, 30 year mortgage, the difference would cost more than $110,325 extra in interest charges. The difference in the monthly payment alone would be $307.
If you rented an apartment, got braces, bought cell phone service, applied for a job that involved handling a lot of money, or needed to get utilities connected, there’s a good chance your score was pulled.
If you have an existing credit card, the issuer is likely to look at your credit score to decide whether to increase your credit line – or charge you a higher interest rate, according to a credit scoring study by the Consumer Federation of America and the National Credit Reporting Association.
Until recently, many Americans didn’t even know this number existed because it was a closely guarded secret in the lending industry. In fact, lenders were prohibited from telling borrowers their credit score. The line of reasoning: The number was the result of analyzing complex financial data that the layperson would have difficulty understanding. Plus, if people knew their score (according to the industry mindset at the time), they might be able to change their behavior to manipulate the score and throw off the whole model, rendering it useless.
All that changed a few years ago, when consumers began finding out about the score and demanding to see it. In an unprecedented move in 2000, online lender E-Loan offered to give consumers their scores for free, with information explaining how the score is calculated and how they might improve it. Fair Isaac responded by cutting E-Loan off from its source of credit reports, effectively crippling its ability to lend money. E-Loan stopped giving away credit scores.
It seems like the deck was being stacked against consumers.
Today, consumers can purchase their credit scores online from a number of different sources and everyone is now entitled to a free copy of their credit reports from all three credit bureaus. It is highly recommended that a consumer examine their credit report for errors once every year. In the credit reports that I have personally looked at, there were errors in over ninety percent of them. As stated before, this can result in thousands of dollars.
What exactly determines a consumer’s credit score?
1. How you pay your bills (35 percent of the score)
The most important factor is how you’ve paid your bills in the past, placing the most emphasis on recent activity. Paying all your bills on time is good. Paying them late on a consistent basis is bad. Having accounts that were sent to collections is worse. Declaring bankruptcy is worst.
2. Amount of money you owe and the amount of available credit (30 percent)
The second most important area is your outstanding debt – how much money you owe on credit cards, car loans, mortgages, home equity lines, etc. Also considered is the total amount of credit you have available. If you have 10 credit cards that each has $10,000 credit limits, that’s $100,000 of available credit. Statistically, people who have a lot of credit available tend to use it, which makes them a less attractive credit risk.
3. Length of credit history (15 percent)
The third factor is the length of your credit history. The longer you’ve had credit – particularly if it’s with the same credit issuers – the more points you get.
4. Mix of credit (10 percent)
The best scores will have a mix of both revolving credit, such as credit cards, and installment credit, such as mortgages and car loans. “Statistically, consumers with a richer variety of experiences are better credit risks,” Watts says. “They know how to handle money.”
5. New credit applications (10 percent)
The final category is your interest in new credit – how many credit applications you’re filling out. The model compensates for people who are rate shopping for the best mortgage or car loan rates. The only time shopping really hurts your score, Watts says, is when you have previous recent credit stumbles, such as late payments or bills sent to collections.
The scoring model doesn’t look at:
job or length of employment at your job
whether you’ve been turned down for credit
length of time at your current address
whether you own a home or rent
information not contained in your credit report
A lender may consider all those factors when deciding whether to approve a loan application, but they aren’t part of how a FICO score is calculated.