Credit Scores: Creating an Influential Number
What is a Credit Score?
A credit score is a number derived from your financial record by a mathematical formula to determine your creditworthiness. This number often is the deciding factor to determine whether you will receive loans, credit, insurance, or job offers.
Although there is more than one way to compute a credit score, most consumers have heard only of the FICO method, but other reliable systems do exist.
The purpose of credit scores is to assess the risk involved for a lender to be repaid and for new employers to find dependable and trustworthy people. It is also used by landlords to find suitable renters, and insurance companies to help make decisions on selling policies.
Interpreting a Credit Score
If you want to interpret your credit score, you first need to determine what type of scoring system was used.
Among the three credit reporting agencies (CRAs), Equifax and TransUnion use the more familiar FICO scores, while Experian uses the less popular “PLUS” scoring system. And all three CRAs use another scoring system called VantageScore, which competes with FICO.
In addition, there are other systems which are used to provide educational insight into scores, but are not used to underwrite loans. These include “Score X” from Experian and “TransRisk” from TransUnion.
With the more common FICO score, the numbers can range from 300 to 850, with the median score for American consumers at 723. Lenders consider scores below 600 to fall into the high-risk level where borrowers often default on loans, while 650 represents an average credit-user and those scores above 690 are considered excellent.
The Experian PLUS credit scoring system ranges from 330 to 830, and the VantageScore system ranges from 501 to 990.
How Credit Scores Are Calculated
Since it is a proprietary tool, the FICO score formula of the Fair Isaac Corporation has never been revealed, but it is known that the calculation is divided into five categories as follows.
- Amount owed (30%)
- Payment history (35%)
- Credit history length (15%)
- New credit inquiries (10%)
- Credit type (10%)
As your past payment record is the best indicator of your future creditworthiness, payment history has the largest percentage of the categories. In this category, problems such as bankruptcies, delinquencies, and debt collections are the drawbacks.
In payment history, several considerations influence how negative factors are viewed, such as the amount involved, the date of occurrence, and how long it took to resolve them. Understandably, the greater the number of negative entries, the lower the credit score.
In amounts owed to lenders, consideration is given to the sum owed, the account type, and the number of accounts. This category is considered a reflection of your current financial situation. A credit score will be lower if there are too many creditors and large outstanding debts.
In the credit history category, the longer a good credit history is maintained, the better will be your score. A twenty-year credit history will be better than a two-year history.
A consumer’s financial distress may be indicated by too many credit applications and each application will slightly lower a credit score.
If you have only one or two credit cards, you are considered less of a risk. Multiple cards carry a higher risk of default and will usually lead to a lower credit score.
Other Determining Factors
Since your credit score is solely based on the information contained in your credit report, other factors may also be consider by lenders, such as your current income and length of employment.
If your job is a high-paying position, you are considered a better risk than, perhaps, a seasonal worker. And if you have worked in that position for a long time, you are less of a risk than someone who was recently hired.
References:
1. Federal Trade Commission, Credit Scoring, September 21, 2000, http://www.ftc.gov/os/2000/09/creditscoring.htm
2. MyFico, About Credit Scores, http://www.myfico.com/crediteducation/creditscores.aspx