Credit Scoring

Vol. X, No. 2 October, 2000

Summary What do lenders look at when deciding whether to approve a loan? Typically, lenders making almost any kind of credit decision will look at a variety of information, including one or more credit scores. A credit score is a number that helps a lender determine how likely an individual is to repay a loan, or make credit payments on time. They are usually derived by looking at data in five categories: payment history, amounts owed, length of credit history, new credit, and types of credit in use.

INTRODUCTION

What do lenders look at when deciding whether to approve a loan? Typically, lenders making almost any kind of credit decision will look at a variety of information, including one or more credit scores. While there are many kinds of credit scores, the most frequently used are credit bureau risk scores developed by Fair, Isaac. These are commonly known as FICO® scores, although they have different names at each of the national credit reporting agencies.

A credit score is a number that helps a lender determine how likely an individual is to repay a loan, or make credit payments on time. When a lender requests a credit report and score from a credit reporting agency, the score is calculated from a "scorecard" or scoring model - a mathematical equation that evaluates many types of information from the applicant's credit report at that agency. By comparing this information to the patterns in thousands of past credit reports, scoring identifies one's level of credit risk.

CATEGORIES OF INFORMATION FICO SCORES CONSIDER

Listed below are the five main categories of information on a credit report that Fair, Isaac scores evaluate, along with their general level of importance. Within these categories is a complete list of the information that goes into a FICO score. Please note that:

• A score takes into consideration all these categories of information, not just one or two. No one piece of information or factor will determine a score.
• The importance of any factor depends on the overall information in one's credit report.
• Your score only looks at information in your credit report. Lenders look at many things when making a credit decision, including your income and the kind of credit you are applying for.
• Your score considers both positive and negative information in your credit report. Late payments will lower your score, but having a good record of making payments on time will raise your score.
• Your score does not consider your ethnic group, religion, gender, marital status and nationality. These are, in fact, prohibited from use in scoring by U.S. law.

Payment History - What is your track record?

The first thing any lender would want to know is whether you have paid past credit accounts on time. This is also one of the most important factors in a credit score. An overall good credit picture can outweigh one or two instances of, say, late credit card payments. By the same token, having no late payments in your credit report doesn't mean you will get a "perfect score." Your score takes into account:

• Payment information on many types of accounts. These will include credit cards, retail accounts, installment loans, finance company accounts, and mortgage loans.
• Public record and collection items - reports of events such as bankruptcies, judgments, suits, liens, wage attachments, and collection items.
• Details on late or missed payments and public record and collection items; specifically, how late they were, how much was owed, how recently they occurred, and how many there are. Note that closing an account on which you had previously missed a payment does not make the late payment disappear from your credit report.
• How many accounts show no late payments. A good track record on most of your credit accounts will increase your credit score.

Approximately 35% of the credit score is based on this category.

Amounts Owed - How much is too much?

Having credit accounts and owing money on them does not mean you are a high-risk borrower with a low score. However, owing a great deal of money on many accounts can indicate that a person is overextended, and is more likely to make some payments late or not at all. Part of the science of scoring is determining how much is too much for a given credit profile. Your score takes into account:

• The amount owed on all accounts. Note that even if you pay off your credit cards in full every month, your credit report may show a balance on those cards.
• The amount owed on all accounts, and on different types of accounts. In addition to the overall amount you owe, the score considers the amount you owe on specific types of accounts, such as credit cards and installment loans.
• Whether you are showing a balance on certain types of accounts. In some cases, having a very small balance without missing a payment shows that you have managed credit responsibly, and may be slightly better than no balance at all.
• How much of the total credit line is being used on credit cards and other "revolving credit" accounts. Someone closer to "maxing out" on many credit cards may have trouble making payments in the future.
• How much of installment loan accounts is still owed, compared with the original loan amounts. Paying down installment loans is a good sign that you are able and willing to manage and repay debt.

Approximately 30% of your score is based on this category.

Length of Credit History - How established is yours?

In general, a longer credit history will increase your score. However, even people with short credit histories may get high scores, depending on how the rest of the credit report looks. Your score takes into account:

• How long specific credit accounts have been established.
• How long your credit accounts have been established, in general. The score considers both the age of your oldest account and an average age of all your accounts.
• How long it has been since you used certain accounts.

Approximately 15% of the score is based on this category.

New Credit - Are you taking on more debt?

People tend to have more credit today and to shop for credit - via the Internet and other channels - more frequently than ever. Fair, Isaac scores reflect this fact. Research shows that opening several credit accounts in a short period of time does represent greater risk - especially for people who do not have a long-established credit history. Your score takes into account:

• How many new accounts you have. The score looks at how many new accounts there are by type of account (for example, how many newly opened credit cards you have). It also may look at how many of your accounts are new accounts.
• How long it has been since you opened a new account. Again, the score looks at this by type of account.
• How many recent requests for credit you have made, as indicated by inquiries to the credit reporting agencies. This is considered a "consumer-initiated inquiry," not an indication that you are seeking new credit. Also, the score does not count it when a lender requests your credit report or score in order to make you a "pre-approved" credit offer.
• Length of time since credit report inquiries were made by lenders.
• Whether you have a good recent credit history, following past payment problems. Re-establishing credit and making payments on time after a period of late payment behavior will help to raise a score over time.

Approximately 10% of the score is based on this category.

Types of Credit in Use - Is it a "healthy" mix?

The score will consider your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. The credit mix usually won't be a key factor in determining your score - but it will be more important if your credit report does not have a lot of other information on which to base a score. Your score takes into account:

• What kinds of credit accounts you have, and how many of each. The score also looks at the total number of accounts you have. For different credit profiles, how many is too many will vary.

Approximately 10% of the score is based on this category.

USING SCORE REASON CODES TO UNDERSTAND YOUR SCORE

When a lender receives your Fair, Isaac credit bureau risk score, up to four "score reason codes" are also delivered. These explain the top reasons why your score was not higher. They say things like "Number of accounts with delinquency." If the lender rejects your request for credit, these reason codes can help the lender tell you why your score wasn't higher.

These reason codes are more helpful than the score itself in helping you determine whether your credit report might contain errors, and how you might improve your score over time. However, if you already have a high score (for example, in the mid-700s) some of the reason codes may not be very helpful, as they may be marginal factors related to the last three categories above.

A NOTE ABOUT FAIR, ISSAC SCORES

Fair, Isaac credit bureau risk scores are available to lenders through the major credit reporting agencies (Experian, Equifax and Trans Union). The score from each credit reporting agency considers only the data in your credit report at that agency. This is why you may have a different score from each of the credit reporting agencies.

FICO credit bureau risk scores are calculated by the credit reporting agency, using Fair, Isaac's scoring models, when the score is requested by a lender. Only the credit reporting agencies have the data needed to calculate a FICO score. To get a copy of your credit report or to correct information in the report, contact the credit reporting agency directly:

• Experian, P.O. Box 740241, Atlanta, GA 30374-0241, (800) 685-1111.
• Equifax, P.O. Box 949, Allen, TX 75013, (800) 682-7654,
• Trans Union, 760 West Sproul Road, P.O. Box 390, Springfield, PA 19064-0390, (800) 888-4213.