What is a credit score?
A credit score is a 3-digit number that is used to predict the likelihood that a consumer will pay back a loan or financial obligation. This number is calculated based on algorithms used to predict various circumstances, such as default, bankruptcy, or revenue. The most commonly used and known credit scores are the FICO scores. The scores are based on all the information in your credit report and is a quick rating summing up your overall credit health. Almost like a snapshot of your credit report! As new information is being added, old information is being removed and the score calculated today can change tomorrow.
The record maintained by the credit reporting agencies (CRAs) or otherwise known as credit bureaus is the basis of your credit scores. Computers are used to analyze your credit report data to generate a statistical number, referred to as a credit score. This number is used to indicate your payment history or the likelihood that you will pay a loan or financial obligation back.
Credit scoring models use multivariate formulas (tons of variables). To understand how this works, we will use a noncredit example. Say your sibling was coming to see you and are late getting there. Where is this person, you may ask yourself. To answer this question, you will need to review what you know about the person, including;
- Is this person forgetful?
- Does this person often run late for things?
- Has this person ever been late to your house before?
- Is this person walking or driving?
- Did this person stop off for gas, if driving?
Using all of these variables, you could try and predict where this person is. The number of factors of the credit scoring formula evaluates is much greater, of course, so you can see how difficult it can be to predict credit outcomes.
The massive algorithms and multivariate calculations compare groups of people based on similarities. Due to the grouping aspect of calculations, a credit score is not based on one person's individual credit, but that person's credit based on similarities of others and prior statistical data, which is an ever-changing model. Example: In the future a single foreclosure may not have much of an impact as it did in the past if a larger amount of people with a foreclosure keep that foreclosure as an isolated incident, it does not affect the rest of their credit. This example is a prediction of what will happen in the future based on what we see in today's market. The statistical data that changes the FICO scoring models could take years to adapt but, is important to understanding why and how the confusing calculations work.
Originally, credit scoring focused on the decision to accept or reject an application for credit. Basically, a pass or fail decision-making system. Over time, it expanded into other aspects of the lending process, including what interest rates to charge, the review of current account holders, and the solicitation of new loans.
What is NOT counted in a credit score?
A federal law called the Equal Credit Opportunity Act and Consumer Credit Protection Act prohibits certain things from being factored into a credit score. Below, is a list of these items not counted in a credit score:
- Race, color, religion, national origin, sex, and marital status.
- Salary, occupation, title, employer, date employed or employment history
- Demographics, or where you live
- Interest rate being charged on a certain credit card or account
- Items reported as child support obligations or rental agreements
- Information not found in your credit report
- Information not proven to be predictive of future credit performance
- Certain types of inquiries to include;
(a) Consumer inquiries - requests made by the consumer to look at their credit reports.
(b) Promotional inquiries - requests made by lenders to make a pre-approval or credit offer.
(c) Administrative inquiries - requests made by lenders to review your account with them.
(d) requests made from employers are not counted either.
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