Credit score (United States)
From Wikipedia, the free encyclopedia
In the United States, a credit score is a number typically between 300 and 850, based on a statistical analysis of a person's credit files, to represent the creditworthiness of that person, which is the likelihood that the person will pay his or her bills. A credit score is primarily based on credit report information, typically from the three major credit bureaus.
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. Lenders use credit scores to determine who qualifies for a loan, at what interest rate, and what credit limits. The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system. While the most widely known score in the United States is FICO (which is most widely used in the mortgage industry), there are many others, such as NextGen, VantageScore and the CE Score.
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[edit] The FICO score and others
FICO is an acronym for Fair Isaac Corporation, which is the most well-known credit score model currently in the United States. The FICO score is calculated by applying statistical methods, developed by Fair Isaac, to information in one's credit file. The FICO score is primarily used in the consumer banking and credit industry. Banks and other institutions that use scores as a factor in their lending decisions may deny credit, charge higher interest rates, or require more extensive income and asset verification if the applicant's credit score is low.
FICO scores show how likely it is that a borrower will default. No public information is available to determine what the scores mean in terms of statistics. A separate score, BNI, is used to indicate likelihood of bankruptcy.
Although Fair Isaac's Web site offers to sell consumers their "FICO score," the company actually uses slightly different scoring methods to rate a consumer's suitability for three different types of credit—mortgages, auto loans, and consumer credit—reflecting the differing risks of these various types of lending. It is not unusual for these scores to differ by fifty points or more for the same borrower. (The number offered to consumers is the consumer credit score.)
In the US, three major credit reporting agencies (often times inaccurately referred to as "credit bureaus"), Equifax, Experian and TransUnion, also calculate their own credit scores. Scores, many with trademarked names, differ by what they are meant to predict, statistical methods used to determine a score, as well as what information is used and how it is weighted. For example, Beacon, Beacon 5.0, Beacon 96, and Pinnacle scores are available only from Equifax; Empirica, Empirica Auto 95, Precision Score, and Precision 03 at TransUnion; and Fair Isaac Risk Score at Experian. While these versions are developed for the agencies by Fair Isaac, they differ and are periodically updated to reflect current consumer repayment behavior. The NextGen Score is a scoring model designed for consumers. Other consumer scores are published by MyFICO.com and by Community Empower (the CE Score).
In 2006, in an attempt to make scoring more consistent, the three major credit reporting agencies introduced VantageScore. VantageScore uses a different range from FICO (from 501 to 990) and also assigns letter grades from A to F to specific ranges of scores. A consumer's VantageScore may still differ from agency to agency, but the discrepancies would be entirely due to differences in the information reported to the various agencies, not due to differences in scoring models. Since FICO is still widely used by lenders, the agencies continue to offer FICO scores (or their closest equivalent) as well.
Most scores use a multiple-scorecard design. Each version may use individual scorecards, and an individual is typically compared with other consumers. (For example, a borrower with two 30-day late payments will be scored against a population with some similar delinquencies.) The individual is then graded according to which variables indicate a repayment risk in that group.
Nearly all large banks also build and use their own proprietary statistical models for credit scoring purposes, often in conjunction with outside scoring formulas.
The statistical models that generate credit scores are subject to federal regulations. The Federal Reserve Board's Regulation B, which implements the Equal Credit Opportunity Act, expressly prohibits a credit scoring model from considering any "prohibited basis" such as race, color, religion, national origin, sex, or marital status. It also stipulates that credit scoring models must be empirically derived and statistically sound. Furthermore, if an adverse action is taken as a result of the credit score (e.g. an individual's application for credit is denied) then specific reasons for the denial must be provided to the individual. A statement that the individual "failed to score high enough" is insufficient; the reasons must be specific ("too many delinquencies 60 days or greater").
There are several generally accepted algorithms for extracting the primary contributing factors to a low credit score. One or more of these algorithms is typically used to supply a list of reasons when a loan applicant has been denied credit, in order to satisfy the Regulation B requirement that specific reasons are disclosed.
For ease of use, most scores are mathematically scaled so that they fall in the same general range as prominent scoring model competitors. Since Fair Isaac provides the dominant scoring methodology, non-Fair Isaac scores are often designed to mimic FICO scores and are sometimes derisively referred to as "FAKO" scores. [1] Although not as widely used, these scores (for example, TransUnion's "TransRisk" score or Experian's "ScoreX" and "PLUS" scores) are less expensive than the FICO score. The cost savings of a non-FICO score are tempting to some banks and credit card companies, who need an accurate risk assessment on millions of accounts every year.
Fair Isaac offers scoring models for the U.S., Canada, and South Africa, and the firm also offers a "Global FICO" for many other countries.
[edit] Makeup of the credit score
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, the Fair Isaac Corporation has disclosed the following components and the approximate weighted contribution of each:
- 35% - punctuality of payment in the past (only includes payments later than 30 days past due)
- 30% - the amount of debt, expressed as the ratio of current revolving debt (credit card balances, etc.) to total available revolving credit (credit limits)
- 15% - length of credit history
- 10% - types of credit used (installment, revolving, consumer finance)
- 10% - recent search for credit and/or amount of credit obtained recently
The above percentages provide very limited guidance in understanding a credit score. For example, the 10% of the score allocated to "types of credit used" is undefined, leaving consumers unaware what type of credit mix to pursue. "Length of credit history" is also a murky concept; it consists of multiple factors - two being the oldest account open and the average length of time an account has been open. Although only 35% is attributed to punctuality, if a consumer is substantially late on numerous accounts, his score will fall far more than 35%. Bankruptcies, foreclosures, and judgments affect scores substantially, but are not included in the somewhat simplistic pie chart provided by Fair Isaac.
Current income and employment history do not influence the FICO score, but they are weighed when applying for credit. For instance, an unemployed individual with no other 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 monies owed because of a court judgment, tax lien, or similar carry an additional negative penalty, especially when recent.
- Having more than a certain number of consumer finance credit accounts also carries a negative weight (critics say that this causes a vicious cycle, locking people into continuing to use consumer finance companies).
- The number of recent credit checks also can weigh down the score, although credit agencies usually claim to allow for credit checks made within a certain window of time to not aggregate, so as to allow the consumer to shop around for rates.
[edit] Range of scores
A FICO score generally has a max of 850 and a minimum of 300. It exhibits a left-skewed distribution with a median around 723. The performance of the scores is monitored and the scores are periodically aligned so that a credit grantor normally does not need to be concerned about which score card was employed.
Each individual actually has three credit scores for any given scoring model because the three credit agencies have their own, independent databases. These databases are independent of each other and may contain entirely different data. Many lenders will check an applicant's score from each bureau and use the median score to determine the applicant's credit worthiness.
VantageScore ranges from 501 to 990 and offers letter grades as well: A (901-990), B (801-900), C (701-800), D (601-700), and F (501-600).
[edit] Free annual credit reports
As a result of the FACT Act (Fair and Accurate Credit Transactions Act), each legal U.S. resident is entitled to one free copy of his or her credit report from each credit reporting agency once every twelve months. This information is available at the only government-sanctioned credit reporting agency-operated website, annualcreditreport.com, by calling 1-877-322-8228, or by mailing the Annual Credit Report Request Form. To guard against inaccurate information or fraud more often than yearly, one can request a report from a different credit reporting agency each four months. However, the free report does not contain a credit score, though a credit score may be purchased at the time of access. Requesting a credit report will subject you to "pre-screened" offers of credit cards. To prevent all three credit bureaus from making your address available to credit card companies for this purpose, you may opt out by calling 1-888-5-OPT-OUT (1-888-567-8688).
Equifax and Fair Isaac teamed up to provide consumers with their FICO credit scores. The other two credit bureaus, TransUnion and Experian, also sell their scores to consumers. Experian calls its credit score product PLUS Score. The PLUS Score ranges from 330 to 830.
[edit] Non-traditional uses of credit scores
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.[1]
Credit scores are often used in determining prices for auto and homeowner insurance. Recently, some of the agencies that generate credit scores have also been generating more specialized insurance scores, which insurance companies then use to rate the quality of potential customers. These scores are unavailable to consumers.
Many employers reserve the right to do a credit check of job applicants, in the same manner they reserve the right to drug test potential employees.
[edit] Building a credit history/score
There are a number of ways to easily build a credit history in the United States. Here are some suggestions, some of which are based on this MSN article:
- Have a family member make the person an authorized user of his or her credit card - doing so will place an entry in the person's credit report. This will even work for minors. This is a good choice only if the card in question has a clean payment history and the family member can be trusted to continue reliably managing it.
- Open checking and savings accounts – according to MSN, lenders see these accounts as signs of financial stability. However, checking and savings accounts do not report to reporting agencies, as they are not an extension of credit. That said, holding bank accounts in good standing will help obtain credit from lenders even if it does not directly impact your credit score.
- Apply for a student credit card – although they have low credit limits, student cards are a great way to build a credit history.
- Apply for a store credit card – such cards are usually easy to obtain.
- Get installment credit – the best credit scores are obtained through the use of installment credit (auto loans, personal loans and mortgages) in addition to revolving credit (credit cards and lines of credit).
- Apply for a secured credit card
[edit] References
[edit] See also
- Fair Credit Reporting Act (FCRA)
- Credit history
- Credit reference
- Adverse Credit History
- Credit card
- Credit rating agency
- Identity theft
- FICA, a similar-sounding acronym in the world of personal finance that people sometimes confound with FICO
