Credit score

Credit card

A credit score in the United States is a number representing the creditworthiness of a person or the likelihood that person will pay his or her debts. It has shown to be very predictive of risk, made credit more widely available to consumers and lowered the cost of providing credit.^[1][2] A credit score is primarily based on a statistical analysis of a person's credit report information, typically from the three major American credit bureaus: Equifax, Experian, and TransUnion. Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers and to mitigate losses due to bad debt. Using credit scores, lenders determine who qualifies for a loan, at what interest rate, and to what credit limits. The Fair Isaac Corporation, known as FICO, created the first credit scoring system in 1958, for American Investments, and the first credit scoring system for a bank credit card in 1970, for American Bank and Trust.^[3]

Each of the three credit bureaus may have different information about any particular person, and there are many different credit scoring models in use, which means a person may have several different credit scores simultaneously. Many lenders use third-party credit scoring systems, such as the FICO scoring model, NextGen, VantageScore, and the CE Score, to evaluate the creditworthiness of a borrower. Because a score does not consider race, sex or ethnicity, it is generally considered to be the most fair and objective underwriting tool available to lenders. The Federal Reserve Board did a study that noted scores have increased the availability of credit and reduced the cost of credit. ^[4] Scores have also proven to be very predictive in assessing risk. ^[4]

FICO score and others

FICO is a publicly-traded corporation (under the ticker symbol FIC) that created the best-known and most widely used credit score model in the United States. The FICO score is calculated statistically, with information from a consumer's credit files. The FICO score is primarily used in credit decisions made by banks and other providers of secured and unsecured credit. It provides a snapshot of risk that banks and other institutions use to help make lending decisions. Banks may deny credit, charge higher interest rates, demand more collateral, or require extensive income and asset verification if the applicant's FICO credit score is low. Applicants with higher FICO scores may be offered better interest rates on financial instruments such as mortgages or automobile loans. Lenders usually establish different credit score cut-offs to determine to whom they are willing to lend.^[5]

Credit reporting agencies

The three credit reporting agencies in the United States of America, Equifax, Experian, and TransUnion, collect data about consumers used to compile credit reports. The credit agencies use FICO software to generate FICO scores, which are sold to lenders. Each individual actually has three credit scores at any given time for any given scoring model because the three credit agencies have their own databases, gather reports from different creditors, and receive information from creditors at different times.^[6]

The FICO company sells FICO scores directly to consumers at myFICO.com using data from Equifax and TransUnion. Equifax and TransUnion also sell FICO scores directly to consumers.

NextGen score

The NextGen Score is a scoring model designed by the FICO company for assessing consumer credit risk. It is similar to the traditional FICO scores with regard to intended use and general design. It has not enjoyed the same level of adoption as the traditional FICO score, but is used by some creditors. Other credit consumer scores are published by Community Empower as the CE Score.

VantageScore

In 2006, to try and win business from FICO, the three major credit-reporting agencies introduced VantageScore. VantageScore uses a number range (501 to 990), which is different from FICO's, and assigns letter grades (A to F) to specific score ranges. A borrower's VantageScore may differ from bureau to bureau, but discrepancies stem from data differences in the reported credit information, not because of differences among credit-scoring mathematical models, similar to FICO^[7]. Since FICO remains as the widely-used score by money lenders, the agencies continue offering FICO scores or something similar.

Facts

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Most scores use a multiple-scorecard design. Each version may use individual scorecards. Typically, a given borrower is compared with other consumers; e.g., a borrower with two 30-day late payments will be scored against a similar delinquent-payer population. The borrower then is graded according to the risk-determining mathematical variables used by the scoring model, ranking him or her within the group of similar borrowers. Most large banks build and use their own proprietary statistical credit-scoring models, often in conjunction with third-party scoring models.

The statistical models for generating credit scores are subject to federal regulation. The Federal Reserve Board's Regulation B (implementing the Equal Credit Opportunity Act), expressly prohibits a credit-scoring model considering "prohibited biases" such as race, religion, national origin, sex, and marital status. It also states that credit-scoring models must be empirical and statistically sound. Furthermore, if negative action results from a credit score (i.e. a denied application for credit), the lender must state to the borrower the specific reasons for the denial. A statement that the person "failed to score high enough" is insufficient; the reasons must be specific (e.g. "too many delinquencies of 60 days or greater").

There are several generally-accepted algorithms for extrapolating the primary factors generating a low credit score. Typically, one or more of these algorithms is used to list reasons for when a loan applicant is denied credit, in satisfaction of the Regulation B requirement that specific reasons be given to the applicant. These reasons are often specified using a reason code that is more-or-less standardized across scoring models.

For easy use, most scores are mathematically scaled so that they fall in the general range used by prominent scoring model competitors. Since the FICO provides the dominant scoring method; non-FICO scores often mimic FICO scores (and are frequently derisively referred to as "FAKO" scores).^[8] Although not as widely used, these scores (e.g. TransUnion's "TransRisk New Account", Experian's "ScoreX", and "PLUS" scores), may be less expensive to buy than is the FICO score. Banks and credit card companies must choose which score they use based on its predictive accuracy and consistency as well as cost.

The FICO company's offers scoring models are used in the U.S., Canada, Mexico, the United Kingdom, Ireland, Poland, Sweden, Turkey, Bahrain, Saudi Arabia, South Africa, Russia, Singapore, Republic of Korea, Thailand, Taiwan, Brazil, Peru and Panama.^[9]

Makeup of the credit score

The approximate makeup of the FICO score used by U.S. lenders

Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history. Although the exact formulas for calculating credit scores are closely-guarded secrets, FICO has disclosed the following components and the approximate weighted contribution of each: ^[10]

• 35% — Payment History – Late payments on bills, such as a mortgage, credit card or automobile loan, can cause a consumer’s FICO score to drop. Paying bills as agreed over time will improve a consumer’s FICO score.^[11]
• 30% — Credit Utilization - The ratio of current revolving debt (such as credit card balances) to the total available revolving credit (credit limits). Consumers can improve their FICO scores by paying off debt and lowering their utilization ratio.^[12] The closing of existing revolving accounts will typically adversely affect this ratio and therefore have a negative impact on their FICO score.
• 15% — Length of Credit History – As consumer’s credit history ages, assuming they pay their bills, it can have a positive impact on their FICO score.^[13]
• 10% — Types of Credit Used (installment, revolving, consumer finance) – Consumers can benefit by having a history of managing different types of credit.^[14]
• 10% — Recent search for credit and/or amount of credit obtained recently - Multiple credit inquiries for a consumer seeking to open new credit, such as credit cards, retail store accounts, and personal loans, can hurt an individual’s score. Applying for lots of new credit in a short period of time is also viewed as risky and can cause a drop in an individual’s score. However, individuals shopping for a mortgage or auto loan over a short period will likely not experience a decrease in their scores as a result of these types of inquiries.^[15]

Credit scores are not the sole underwriting factor used by lenders. Lenders use their own internal scoring models as well as other loss mitigation tools and data to gauge an individual's creditworthiness.^[16] For instance, current income and employment history, which are not part of a score, are weighed when applying for credit, along with tenancy status (rent or own) in some cases. An unemployed individual with no sources of income will not usually be approved for a home mortgage, regardless of his or her FICO score.

There are other special factors which can weigh on the FICO score.

• Any money owed because of a court judgment, tax lien, or similar carry an additional negative penalty, especially when recent.
• Having one or more consumer finance credit accounts may also carry a negative weight (critics say that this causes a vicious cycle, locking people into continuing to use consumer finance companies).^[17]
• The number of recent credit checks for consumers seeking new credit, such as credit cards or retail store cards, can have a negative impact on the FICO score. However, for consumers shopping for a home or a car, credit inquiries generated for those activities are grouped together as one credit inquiry, and therefore, these inquiries do not impact a consumer’s score.^[15]
• While all credit inquiries are recorded and displayed on your credit report for a period of time, credit inquiries that were made yourself (to check your credit), by your employer (for employee verification) or by companies initiating prescreened offers of credit or insurance do not have any impact on your credit score.

Range of scores

A FICO score is between 300 and 850, exhibiting a left-skewed distribution with 60% of scores near the right between 650 and 799.^[18] According to FICO the median score is 723.^[19] The performance of the scores is monitored and the scores are periodically aligned across scorecards within each scoring model, as well as across the three credit bureaus, so that the score represents the same credit risk to lenders regardless of its source.

Each individual actually has three credit scores for the FICO scoring model because the three national credit bureaus, Experian, Equifax and TransUnion, each has its own database. Consequently, data about an individual consumer can vary from bureau to bureau.^[20][21] These studies point out that people with higher scores have fewer claims. Studies also indicate that the majority of insureds pay less in insurance through the use of scores.^[22][23]

In September 2004, TXU (a Texas utility company) announced it would begin setting individualized electricity prices based on credit score. However, due to negative press and pressure from the Texas Public Utility Commission, the plan was not implemented.^[24]

Some employers, especially financial institutions, will request permission from job applicants to run a credit check as part of their application process. This credit information can be used as an indicator of a person's level of financial responsibility. Note that job applicants have certain rights under the Fair Credit Reporting Act and are not required to consent to a credit check.

Criticisms and controversies

Credit scores can be adversely affected if the information in a credit report is not updated by a lender. Lenders and others that furnish credit information to a credit bureau usually update it every month. If the data furnisher does not report to the bureau that debt has been reduced or paid off, it will stay on the credit report until the debtor finds the error and reports the updated status themselves.

There is the possibility of "doctoring" a person's credit score to increase it. Because a major portion of the FICO score is determined by the ratio of credit used to credit limit, a simple way to increase the score is to simply increase your credit limit. Some credit-repair agencies, for a fee, will report to credit bureaus that they have opened an account with a high credit limit. The customer cannot actually use this account, but it improves the customer's FICO score due to lowering the balance-to-credit-limit ratio.^[25]. This practice is called authorized user account abuse. FICO developed a new version of the FICO score “FICO 08,” which FICO says should significantly limit the ability to tamper with the FICO score through authorized user abuse.^[25]

FICO 08 also includes enhancements in predicting risks of subprime borrowers. Some have blamed lenders for inappropriately approving loans for subprime applicants, despite signs that people with poor scores were at high risk for not repaying the loan. By not considering whether the person could afford the payments if they were to increase in the future, many of these lenders may have put the borrowers at risk for default. ^[26]

According to a Fitch study, the accuracy of FICO in predicting delinquency has reduced in recent years. In 2001 there was an average 31-point difference in the FICO score between borrowers who had defaulted and those who paid on time. By 2006 the difference was only 10 points. Meredith Whitney of CIBC World Markets has called the FICO score "virtually meaningless". Some banks have reduced their reliance on FICO scoring. For example, Golden West Financial (which merged with Wachovia Bank in 2006) abandoned FICO scores for a more costly analysis of a potential borrower's assets and employment before giving a loan. According to Richard Atkinson of Golden West, "some of our best borrowers had low FICO scores and our worst had FICO scores of 750".^{[25][citation needed]}

References

See also

• Fair Credit Reporting Act (FCRA)
• Credit reference
• Credit score, international article
• Credit Scorecards
• Alternative data
• Adverse Credit History
• Credit rating agency
• Identity theft
• Seasoned trade lines, sometimes used to artificially increase FICO scores
• FICA, a similar-sounding acronym in the world of personal finance that people sometimes confuse with FICO
• Comparison of free credit report websites

External links

• US Government FAQ about FACT
• Text of Regulation B, which stipulates the conditions that US credit scoring models must satisfy
• "Credit Scores: What You Should Know About Your Own," by Malgorzata Wozniacka and Snigdha Sen (November 2004) - PBS FRONTLINE
• Tool for estimating ones FICO score.
• The Wall Street Journal: Free Internet Credit Scores