Credit Scoring - How It Works

Have you ever wanted to predict the future? Creditors have a way of doing just that.

Credit scoring is a statistically based computerized method for predicting how likely it is that a borrower will pay back a loan before it's even issued. It automates the process of applying for credit, which saves time and increases accuracy. When a car dealership advertises "instant credit approval," that dealership is using credit scoring.

How Does it Work?

Credit reports from millions of borrowers are compared to each other using a computer program that considers similarities between the reports and whether the borrowers paid some or all of their bills on time. The program puts the reports in rank order, giving each a score-like a grade on a test.

Predictive variables are categories for predicting risk. Your credit score is calculated based on these variables. By looking at your credit score, the creditor can figure out how much risk is involved with loaning you money. The score gives the creditor a way to predict how well you will manage your debt.

Changing the Score

No credit score lasts forever. It changes over time as your credit behavior changes. Think of it as a snapshot of your credit performance at one point in time. Your score can go up or down depending on how you manage your credit.

The credit score, which is based entirely on the credit report, is the creditor's most powerful tool for assessing credit risk. To make sure you score high with your credit history, it's important to understand what factors affect your credit score.

Factors in Credit Scoring

Different types of information, known as factors, are gathered from your credit report to make up your credit score. These factors fall into broad categories, such as payment history and outstanding debt.

Credit scoring models rate the importance of each category to calculate your credit score.

Credit scores reflect credit patterns over time. An adverse action, like a tax lien or bankruptcy filing, can immediately and significantly impact a credit score.

Several factors can have a negative impact on your credit score:

• History of nonpayment
• Public record information
• Evidence of collection accounts
• Recent delinquent accounts
• High balances owed on accounts
• Credit cards charged to their limits
• Too many new accounts

Only the applicant's prior credit history is considered when calculating a credit score. For this reason, credit scoring is considered unbiased. Any factors that would show bias are not allowed.

Your credit score cannot be based on any of these factors:

• Race
• Gender
• Age
• Income level
• National origin
• Sources of income
• Religion
• Marital status

Because income level is not a factor, you could have a low income and a high credit score. Or you could have a high income and a low credit score. It just depends on your credit history.

FICO^® scores, developed by Fair, Isaac and Co., Inc., are the most commonly used credit scores today. According to FICO, the various factors used to calculate credit scores can be grouped into five primary areas:

1. Payment history
2. Outstanding debt
3. How long you have been using credit
4. Pursuit of new credit
5. Types of credit in use

FICO is one credit scoring company. Other companies may use different factors.

How is Your Score Calculated

Five sample factors for calculating credit scores are listed below, along with a sample of the importance each factor has to the total score. As you read through the list, think about how your credit might score today.

• Payment History: 35%. What is your track record? Have your payments been made on time?

• Outstanding Debt: 30%. How much do you owe? Do you have a high level of debt? Are you near the limit on your accounts?

• Credit History: 15%. What is the length of your credit history? Has it only been a few years?

• Pursuit of New Credit: 10%. Have you made numerous applications for new credit? Are you taking on more debt?

• Types of Credit in Use: 10%. Do you use a variety of credit types? The score will consider your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans.

So how does all this math work? Each factor is given a weight or level of importance. This weight is assigned as a percentage (such as 35%, as shown in the example above). The score is graded for each factor, and then each factor is multiplied by the weight. Computers calculate credit scores in an instant.

Article Source: www.freddiemac.com