Understanding Credit Scoring

Your credit score it is one of the most critical factors in your financial life. It determines if you will be approved for a loan or line of credit. A credit score is a mathematically calculated number developed by the Fair Isaac Corporation (FICO) that lenders use to rate potential customers in determining the likelihood that a customer will pay their bills on time. A credit score or credit rating is determined by using five main criteria as defined by MyFico.com: your payment history which accounts for 35% of your credit score, the amounts owed which accounts for 30% of your credit score, the length of your credit history which accounts for 15% of your credit score, new credit which accounts for 10% of your credit score, and the types of credit used which accounts for 10% of your credit score.

Payment history shows the history of how you paid your bills either on time or late but unfortunately does not show if your bills were paid before the due date. Amounts owed shows the total amount of credit you have available. If your balance is near the credit limit this may lower your credit score. The length of history indicates how long you have had credit. If your credit history is 2 years or less could lower your credit score. New credit indicates how many times you have applied for new credit. If you open two many new accounts in a short period of time this may lower your credit score. The types of credit used indicate the types of accounts you have such as revolving or installment accounts. Revolving accounts are usually credit cards and installment accounts are usually mortgages, auto loans, etc.

The FICO credit score model ranges from 300-850 with 850 being an excellent score and 300 being the worst score. The higher the credit score the lower the interest rate you will receive for a loan or line of credit. Having a good credit score can save you thousands of dollars in interest over the life of the loan or line of credit. A good credit score is generally in the range of 660-749 but may vary from lender to lender.

The three major credit bureaus Experian, Equifax and TransUnion use the FICO credit score model. Equifax uses the Beacon credit score, Experian uses the Fair Isaac or Plus score and TransUnion uses the Empirica score. Each credit bureau subscribes to the Fair Isaac’s FICO model of scoring and then integrates their own version of a consumer’s FICO score. The Equifax Beacon score ranges from 340-820. The TransUnion Empirica score ranges from 150-934. The Fair Isaac or Plus score ranges from 330-830.

When applying for credit or a loan if all three credit scores are pulled, the middle score is generally the score used with the application, but according to the Fair Isaac Corporation 75% of mortgage loan applications use the Fair Isaac or Plus score.

Your credit score varies from each bureau because each agency collects their own data from various sources and may collect different data for the same account. Your score can vary anywhere from 5-40 points between the three credit bureaus. Your credit score changes due to updates to your credit file which changes based on account activity such as balance changes or additions to your credit file (i.e. new accounts or deletion of older negative accounts more than 7 or 10 years old). As a result, you may see a difference in your score from one month to the next.

The following criteria are not included in calculating your credit score:

1. If rent or you own a home

2. Income

3. Length of time at your current job

4. Length of time at your current address

5. Whether you’ve been denied credit

However, the above may be considered in approval for a loan in addition to using your credit score.

If you have a low credit score here are 5 things you can do to boost your credit score:

1. Stop using your credit cards and pay with cash.

2. Pay more than the monthly minimum. If you can’t, it’s time to cut spending.

3. Develop a plan to reduce your total debt.

4. Reduce your interest rates, but be careful of the fine print–a credit card with 0% interest could cost you thousands in interest depending on how the credit card is structured.

5. Get a part-time job in addition to your full time job or find ways to reduce expenses and use the extra money to pay down debt.

The major disadvantage of credit scoring is that it relies on information in your credit report which may contain errors. It is estimated that 75% of credit reports contain at least one error. That’s why it is so important that you check your credit report at least once a year to ensure that all information is accurate and up to date.

If you plan on purchasing a large item such as a car, house or investment property, it is best to pull your credit yourself to see if any negative items appear so you can fix those issues before applying for a loan. The best way to understand your credit score is to do research and read the information that is provided when you order your credit report.

Source by Harrine Freeman

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