Credit Score

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Credit Score

A measure of an individual's creditworthiness. Credit scoring involves the quantification of a variety of factors in an individual's background, including a history of default, the current amount of debt, and the length of time that the individual has made purchases on credit. Banks and other financial institutions may use a credit score to determine whether or not an individual is likely to default on a loan, mortgage, or other debt. The FICO score is the most common credit score in the United States.

Credit score.

Your credit score is a number, calculated based on information in your credit report, that lenders use to assess the credit risk you pose and the interest rate they will offer you if they agree to lend you money.

Most lenders use credit scores rather than credit reports since the scores reduce extensive, detailed information about your financial history to a single number.

There are actually two competing credit scoring systems, FICO, which has been the standard, and VantageScore, which was developed by the three major credit bureaus.

Their formulas give different weights to particular types of credit-related behavior, though both put the most emphasis on paying your bills on time. They also have different scoring systems, ranging from 300 to 850 for FICO to 501 to 999 for AdvantageScore. The best -- or lowest -- interest rates go to applicants with the highest scores.

Because your credit score and credit report are based on the same information, it's very unlikely that they will tell a different story. It's smart to check your credit report at least once a year, which you can do for free at www.annualcreditreport.com or by calling 877-322-8228.

It may be a good idea to review your score if you anticipate applying for a major loan, such as a mortgage, in the next six months to a year. That allows time to bring your score up if you fear it's too low.

Credit Score

A single numerical score,based on information in an indi- vidual's credit report,that measures that individual's creditworthiness.

Credit scores are based on statistical studies of the relationship between the different items in a credit report and the likelihood of default. The most widely used credit score is called FICO for Fair Isaac Co., which developed it. FICO scores range from 350 to 850, the higher the better.

Major Determinants of FICO Scores:

Payment History: This is the most important determinant of credit scores. It includes information on the extent to which the subject has made timely payments on mortgage loans, auto loans, credit cards, personal loans, and charge accounts. Delinquencies reduce the score, while timely payments raise it.

Payment history also includes information on bankruptcies, foreclosures, legal judgments, liens, and wage garnishments. These will have a major adverse impact, although the impact declines with the passage of time.

Amount and Distribution of Current Debts: This is the next most important determinant of credit scores. Unlike payment history, however, it is not always intuitively obvious whether more or less debt, or whether more or fewer creditors, will improve a score. Past some point, more debt will lower the score by raising questions about the ability of the borrower to pay it all off. But not having debt will not generate a good score because without debt the subject cannot demonstrate a good payment history.

The FICO genie who generates a score does not have information on a subject's income or financial assets. The genie must make judgments about how much debt is too much from information on the debt alone. On debts with debt limits, it focuses on the relationship between the two. It reduces the score when it sees debts that are at or close to the maximum. On installment loans, the genie likes to see the balances going down. A large number of accounts does not disturb the genie, so long as most of them have no balances.

Age of Accounts: The FICO genie likes old accounts much better than new ones. Old ones indicate stability in credit relationships, whereas new ones might indicate financial distress—if there are many of them.

The genie understands, however, that shopping multiple credit sources can generate many inquiries without indicating financial distress. All inquiries regarding either mortgage loans or auto loans in any 14-day period are treated as one inquiry, and inquiries within 30 days of a score date are disregarded. The genie also disregards inquiries of your own and inquiries from lenders who are considering you for a loan “pre-approval.”

Mix of Credit: This is not an important factor in the equation, which is good because Fair Isaac doesn't reveal exactly what it means. Reading between the lines, however, one can surmise that the genie is allergic to finance company loans.

Reason Codes: Every FICO score is returned with up to four “score factors,” ranked by importance, that indicate why the score was not higher. Examples are “too many delinquencies,” “ratio of balances to credit limits is too high,” and “too many finance company accounts.”

The reason codes mean little to someone with a high score. Those with low scores looking to improve, however, will do well to focus their efforts on the major problem areas indicated by the codes.

Correcting Errors: Credit reports often contain mistakes that lower the subject's credit score. Perhaps the most common is the inclusion of someone else's accounts. Borrowers who find mistakes must take the initiative to get them fixed, which means writing to the repository reporting the erroneous information and detailing the particulars of the error.

Under the Fair Credit Reporting Act (FCRA), a repository has five days from receipt of such a letter to contact the credit grantor that reported the erroneous information and another 35 days to complete its investigation and report back to the borrower. The report must indicate that the error was corrected, or there was no error, or the credit grantor did not respond, in which case the disputed item is dropped from the report.

To exercise your rights under FCRA, you must follow the correct procedures. These are spelled out on my Web site (www.mtgprofessor.com/A%20-%20Credit%20Issues/how_do_you_correct_your_credit_file.htm).

Because fixing errors takes time, it is a good idea for borrowers to check their credit well in advance of entering the market. Your FICO score is available for $14.95 from www.myfico.com.

Some Misperceptions About Credit: Many borrowers have misperceptions about how their behavior will affect their FICO score.

A Skipped Payment Results in One Delinquency: One misperception is that a skipped payment results in one delinquency record. In fact, however, a skipped payment generates a stream of delinquencies until it is paid.

Under the accounting rules used for amortized mortgages, lenders always credit a payment against the earliest unpaid obliga-
tion. If you skip the payment for May, the payment intended for June will be credited to May, leaving the June payment delinquent. Similarly, the payment intended for July will be credited to June, leaving the July payment delinquent.

It would be nice if the mortgage contract allowed a skipped payment now and then. Such contracts exist in the UK and some other countries, but they have appeared in the U.S. only very recently and are not yet widely available. Unless you have one, if you skip a payment but pay regularly thereafter, you remain delinquent (and accumulate late fees) until the skipped payment is made good.

Paying off Delinquent Loans Improves the Score: Another misperception is that a credit score will improve if loans that have been delinquent are made current or paid off. This isn't so. Delinquencies lower credit scores because they show a weak commitment toward meeting obligations. This evidence is not wiped away when the loan is repaid. Only the passage of time, along with a better payment record, will wipe it away. The same is true of bankruptcies, tax liens, and judgments. They remain on the record for a period, even after they have been discharged or released.

Consolidating Balances Improves the Score: Still another misperception is that the consolidation of credit card balances into a smaller number of cards will increase a credit score. It is true that the FICO genie is much more favorably disposed to four credit cards than to 15. However, the genie is even more concerned with the relationship between the balances on the cards and the maximums. It sees cards that are “maxed out” as an indication of financial distress. So if the consolidation resulted in a smaller number of cards with balances close to their maximums, the score might drop rather than rise.

Authorized Credit Card Users Are Safe: Some borrowers have been surprised to find that their credit score has been reduced by delinquencies on credit cards for which they are not responsible. They are authorized users of cards on which the original credit card holder stopped paying. Even though they are not responsible for making the payment, credit grantors sometimes report authorized users to the credit-reporting agencies as delinquent. Unable to collect from the responsible parties, the original card-holders, the credit grantors hope that maybe the authorized users will pay in order to keep their credit records clean.

To fix this, write the credit-reporting agency, as follows:
I'm an authorized user only and am not financially responsible for this debt. By reporting me delinquent, you are impugning my credit reputation in full violation of the Fair Credit Reporting Act (FCRA). I am aware of my rights under the Act. I intend to enforce them if you don't immediately remove all derogatory information from my credit profile that you placed there as a result of non-payment by the financially responsible party.

If this doesn't work, go to my Web site for step two. (Look in the table of contents under “Credit Issues”/“Are Authorized Users at Risk?”)

Credit and Income Can Be Separated in a Loan Application:

Some couples want to use the credit score of one spouse (the one with the good score) while qualifying with the income of the other. This doesn't work. Lenders are concerned with the credit score of the borrower whose income they are depending on to service the loan.

Use of FICO Scores by Lenders: Most lenders now incorporate FICO scores in their pricing and qualification requirements, but they do it in all sorts of ways. One lender might have 10 different interest rates corresponding to 10 FICO score categories. Another might only use three categories. Still another might set a single FICO score minimum for all loans, but require higher scores for borrowers who want no-down-payment loans, or less than full documentation. Some lenders use FICO scores but supplement them with other information from the credit report that they believe is not adequately weighted in the score.

Because the different credit repositories may have different information, lenders typically get two FICO scores and use the lower of the two. Sometimes they get three and use the middle score.

Lenders dealing with applicants who have low scores because of a foreclosure or bankruptcy will often request a letter of explanation. The purpose is to determine whether the event was caused by recklessness and, therefore, likely to recur or by unusual and unforeseeable misfortunes that were beyond the applicant's control.

Applicants in this situation should realize that the burden of proof is on them. They must persuade the lender that the misfortune was a one-time event that is very unlikely to recur.

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