What is a credit score?
A credit score is a 3-digit number that is used to determine a person's credit worthiness or a prediction of a person's ability to pay back a loan or financial obligation. This number is calculated based on algorithms used in a variety of potential circumstances, such as default, bankruptcy, and revenue etc. The most commonly used credit scores are the FICO scores.
How are credit scores calculated?
Payment History - This is the top-rated factor for both Vantage and FICO credit scoring models. This is because lenders want to know a person's payment history -- past and present. This category is broken down into 3 subcategories:
- Recency - this is the last time that a payment was late. The more time passes, the better.
- Frequency - One late payment looks better than a dozen late payments.
- Severity - Rests on the logic that one payment of 30-days late is not as serious as a 60-day or 120-day late payments. Collections, judgments, charge-offs, repossessions, foreclosures, and bankruptcies are credit score killers
Utilization rate/Amounts Owed - the credit utilization rate is based on revolving account balances versus their credit limits. People who max out their limits have a much greater risk of default. When it comes to revolving debt-credit cards, the formula looks at the difference between the high limit and balances. For example, say you have a credit card (Visa) with a credit limit of $10,000 and you spend $2,000 of it. To find out the credit utilization rate, take the balance ($2,000) and divide into the credit limit ($10,000). This is a 20% utilization ratio. *The lower your ratio, the higher your credit scores.
Length of credit history/Depth of credit - This is less important than the two previous factors mentioned, but still matters. It considers (1) the age of the oldest account and (2) the average age of all your accounts.
Types of credit used/Mix of credit - Both scoring models, FICO and Vantage scores want to see a healthy mix of credit, but are vague on what this means. However, they recommend that people have a balance of both revolving and installment accounts. Revolving accounts are credit cards, while installment accounts are loans such as mortgage, auto, and personal.
New credit/Inquiries - New credit is not always a bad thing. However, opening new accounts can hurt a credit score, especially if someone applies for too much credit in a short time and does not have a long credit history. The score factors in the following:
- How many accounts that a person has applied for recently.
- How many new accounts that a person has opened.
- How much time has passed since a person applied for credit.
- How much time has passed since a person opened an account.
What is not counted in credit scores?
A federal law called the Equal Credit Opportunity Act and Consumer Credit Protection Act prohibits certain things from being factored into credit scores. These things include the following:
- Race, color, religion, national origin, sex and marital status
- Salary, occupation, title, employer, date employed, and employment history. Lenders may consider this information, however.
- Where you live or your demographic
- Any interest rate being changed on a certain credit card or account
- Any information not found in your credit report
- Any information that is not proven to be predictive of future credit performance
- Certain types of inquiries. (1) Initiated requests by the consumer - requests that you have made for your credit report to check on it. (2) Promotional inquiries are requests made by lenders to make you a pre-approval credit offer and (3) administrative inquiries are requests marked as coming from employers.
Why do credit scores vary between the bureaus?
There are several reasons that credit scores vary amongst the three major credit bureaus. The first reason is not all creditors report their information to all three bureaus, and if they do, they may not report the same information at the same time to each agency. The second reason is each bureau or reseller uses its own customized version of the FICO credit scoring model. Because each credit reporting agency uses FICO model developed specifically for that agency and its data, the credit scores it generates will differ.
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