Home Equity Loan
Credit Score
A credit score is a number that represents an estimate of an individual's financial creditworthiness as calculated by a statistical model. A credit score attempts to quantify the likelihood that a prospective borrower will fail to repay a loan or other credit obligation satisfactorily. A credit score is based on a subset of the information in an individual's credit report. Lenders such as banks and credit card companies use credit scores to manage the risk posed by lending money to consumers. Examples of such uses include determining who qualifies for a loan, assigning an interest rate, assigning credit limits, and managing accounts that are already open (for example, treatment of accounts that are in default). The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system.
The FICO score
FICO, an acronym for Fair Isaac Corporation (traded publicly under the symbol
FIC) often refers to the best-known credit score in the United States which is
calculated using mathematical formulae developed by this company. This score is
one of the most important factors in obtaining credit in the United States. For
institutions that use scores as a factor in their lending decisions, scores
below certain numbers (typically set by each lender's risk management
department) may result in denial of credit, or credit being offered at a higher
interest rate.
The three major credit reporting agencies in the United States, (Equifax,
Experian and Trans Union) calculate their own versions of this score, which goes
by different trademark names at each credit bureau: Beacon at Equifax; Empirica
at Trans Union, and Fair Isaac Risk Score at Experian. These versions, while all
developed for the agencies by Fair Isaac, are believed to differ slightly. Fair
Isaac also offers multiple variations on their popular score, for example
"Classic" FICO or "Next Gen" FICO.
It is worth mentioning that each of these credit reporting agencies also have
developed their own separate proprietary versions of a credit score intended to
compete with Fair Isaac's score. Although not the "gold standard", these scores
(for example Trans Union's "TransRisk" score or Experian's "ScoreX" score) are
much less expensive than the FICO score; and often out-perform the FICO score at
its intended purpose which is to determine the risk level of a prospective
borrower. The cost savings of a non-FICO score are very tempting to banks and
credit card companies who need an accurate risk assessment on millions of
accounts every year. Only time will tell if these cheaper and possibly superior
alternative scores will displace Fair Isaac from its dominant position in the
U.S. market for credit scores.
Nearly all large banks also build and use their own proprietary statistical
models for credit scoring purposes, often in conjunction with the FICO score or
other outside scores.
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. Regulation B 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.
There exist 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. Some consumers feel these adverse action reasons are somewhat
disingenuous, as the only determining factor for credit denials is a numeric
score -- the "reasons" are summed up only for the consumer.
As mentioned above, each credit bureau also has one or more of its own generic
credit scores, available both to consumers on their websites and to lenders. For
ease of use, these scores tend to be mathematically scaled so that they fall in
the same general range as the FICO score. These scores are used by some
businesses to assess creditworthiness (otherwise they would not be offered),
however the FICO score remains the dominant score in use today.
Credit Scores available online
FICO scores are available online, on websites such as http://www.myfico.com, for about $45 for scores from all three bureaus. This is significantly more than potential creditors pay for the same information.
Makeup of the FICO score
FICO scores and its variants are designed to measure the risk of default, by taking into account various factors. Although the exact formula for calculating the FICO score is a closely guarded secret, Fair Isaac has disclosed the following components and the approximate weighted contribution of each:
(a) 35% punctuality of payment in the past
(b) 30% capacity used, i.e., ratio of current revolving debt (e.g. credit card
balances) to total available revolving credit (e.g. credit limits)
(c) 15% length of credit history
(d) 10% types of credit used
(installment, revolving, consumer finance)
(e)
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, the average length of time an account has been
open.
Further, Fair Isaac does not use the same "scorecard" for everyone. The
scorecards are segmented so that there are over 100 different actual scoring
models that are applied to different individuals based on different ranges of
input values (some scorecard segmentations include: age, depth of credit
history, etc.). The implications of this segmentation are that while the
approximate weighted contribution above may be an average across all scorecards,
individuals will receive different scores or weightings based on the scorecard
segmentation that they fall into.
Current income and employment history do not influence the FICO score, but they
are also weighed when applying for credit. For instance, an unemployed
individual 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 judgement, tax lien, or similar carry an
extra negative penalty, especially when recent.
Having above a certain number of consumer finance company 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 the credit agencies allow for credit checks made within a certain window of time to not aggregate, so as to allow the consumer to shop around.
Range of scores
FICO scores range from about 300 to 850 and exhibit a left-skewed distribution with a US median around 725. A score above 589 is considered to be "good credit," and a score below 200 is considered to be poor.
Free annual credit reports
As a result of the FACT Act (Fair and Accurate Credit Transactions Act), each U.S. resident is entitled to one free copy of their credit report from each credit reporting agency each year. For those with internet access, this information is available at the U.S. government-operated http://www.annualcreditreport.com. However, this report does not contain credit scores. Mostly useless consumer "credit scores", not used by any businesses, are offered for purchase at the time these reports are generated. Many other commercial websites offer free credit reports; usually these sites attempt to steer consumers to pay services.
Non-traditional uses of credit scores
In September 2004, a Texas utility company began setting individualized
electricity prices based on credit score.
Recently, some of the agencies which generate credit scores have also been
generating insurance scores, which insurance companies then use to rate the
quality of potential customers.
Ways of improving a FICO score
Since the method used to calculate the credit score is essentially just a complicated formula, one can change the score by causing changes in the variables that are important factors in the equation. There are several approaches:
Credit counseling
Various credit counseling organizations exist. Their services are often free of charge. These organizations have by-the-book approaches to money and debt management, and gradually improving your credit over a period of time.
Credit repair
Many for-fee credit repair organizations also exist. These organizations employ less standard solutions. Many websites recommend against using credit-repair organizations, claiming that their tactics are illegal. A typical example of an illegal credit repair approach is to obtain a Employee Identification Number (EIN) and use this when applying for a credit (it is the same length as a Social Security Number and is tied to your name in the same way). This is illegal however and a blank credit report might look just as bad as one with a derogatory item on it. Some credit repair organizations claim immense improvements in scores in very short periods of time. Costs may be high and results are not usually guaranteed.
Do it yourself
Though professionals may have useful advice, there are a number of ways to improve your FICO score. Because the exact formula is not known, the following suggestions are not guarantees, but nevertheless are likely to result in a higher (better) score:
Check credit reports for accuracy
The first strategy to pursue in improving a FICO score is recommended by every
credit repair organization and credit bureau.
Get your free annual reports from http://www.annualcreditreport.com if you don't
have them already.
Find any inaccuracies in your reports. Credit reports are notoriously
inaccurate. Check all information, not just information marked "negative". Even
incorrect neutral information may weigh negatively on your report. For example,
if your credit limit is stated incorrectly low, it will appear that you are
using a higher percentage of your total capacity. This will lower your score.
Dispute these inaccuracies immediately. You may dispute with the creditors
directly or with the bureaus. Creditors tend to have live operators while
bureaus do not.
Many sources recommend filing disputes with bureaus through certified "return
receipt" mail. Disputes can also be files on the credit bureau's websites,
though the options are somewhat inflexible these sites. This usually works for
information that is genuinely incorrect.
Punctuality
It goes without saying that punctuality will improve your FICO score.
Punctuality will not help in the short term, but over the course of a year,
paying bills on time will increase your score by roughly 30 points, and, more
importantly, will prevent your score from dropping.
Pay bills on time, since any payments more than 30 days late will affect the
credit score. Note that a bill issued March 15 with a due date of March 31 does
not become 30 days late until April 30, but if you have the means, pay earlier
rather than later. A single late payment may result in a drop of over 20 points.
Later payments have increasingly worse effects on your score, so pay off late
bills as soon as possible (after negotiating to have derogatory remarks removed
from your report). Additionally, "collection" accounts are much worse than late
payments. Accounts usually go into "collection" status after about six months of
non-payment.
Set up as many automated payments as possible. This will help avoid neglecting
to pay a bill in the future (be sure to maintain enough funds in the bank
account making the payments). Payments by internet are also much quicker than
licking a stamp and dropping an envelope in the mail.
Cleaning up derogatory statements
Negotiate with collectors and businesses to remove any late payments or
collections from a credit report. Often, collectors will happily remove notices
off a credit report in exchange for prompt payment. Many collection agents are
paid on commission and will bend every rule to be paid. It is important for
consumers to obtain any agreement in writing, as once collectors have been paid
off it is mostly impossible to have statements removed. Small billing offices,
such as medical billing offices, are less by-the-book and often open to removing
late remarks from bills paid in the past.
Businesses will usually remove negative remarks in exchange for more business.
This works best when the credit branch of the business is closely connected to
the sales branch, and when you are a significant customer. Businsses have little
interest in preserving the accuracy of a customer's report for other businesses
to review.
If you have federal student loans that fell into default, pursue loan
"rehabilitation" policies. Labels of "collection" or "default" will be removed
from a loan's history with regular payments over the course of a year. This
needs to be arranged ahead of time.
Per-campus student loan programs will often make exceptions and remove negative
remarks if you find the right person to talk to. A good justification for a late
payment ("I never got the bill") never hurts, but remember that most excuses
will not have legal merit (expect responses such as "It was your responsibility
to pay, even if the bill never arrived"). Appealing to human decency and sense
of campus community are vital. If lower ranking officials refuse to help,
letters to higher ranking campus officials may find success.
Be polite, and once in a blue moon things will be removed without hassle. Often
collectors are unhappy people due to constant conflict. Other times they work in
overseas call centers and feel little connection to the people calling them.
Treat them as human beings and they may respond with reasonable negotiations.
Nothing is gained through combativeness or disrespect in the first few contacts.
When none of the above work, threaten and/or pursue legal action. Collectors and
businesses have nothing to gain by reporting negative information about you.
Even a minor legal interaction can cost thousands of dollars. Many businesses
and creditors would rather remove items than deal with a lawsuit. Even bureaus
themselves can be threatened, however, many consumers threaten and do sue credit
bureaus, so the credit bureaus are somewhat accustomed to such threats. Threats
to write the FTC and Congress also have limited effect.
If the above approaches do not apply or fail, file disputes of negative marks on
a credit report. Even if the negative marks are accurate, some creditors fail to
respond to disputes in a timely fashion, which removes negative marks. Rather
than pay the postage it takes to respond, some creditors disregard any
communications regarding paid accounts. It is mail fraud to falsely dispute an
item, but as long as you claim to believe an item was never late, feel free to
dispute.
Decreasing credit capacity used
Decreasing the ratio of debt to credit capacity consists of two major approaches
-- increasing total capacity and decreasing your debt.
Increase limits on credit cards. The FICO formula weighs the ratio of balances
to available credit, so if credit limits are increased while balances stay the
same, this ratio drops and your score increases. If possible, try to increase
limits without triggering credit check, as a credit check will drop a score by
roughly 5 points.
Use relationships with banks and other businesses. Banks will often remove late
notations for valued customers. When a consumer is turned down for credit cards
elsewhere, a bank will often provide a low-limit credit card. This card will
increase capacity (decreasing the capacity used ratio), even if only by a small
amount.
Consider secured credit cards. Secured cards factor into credit scores in
fashion identical to unsecured cards. If a consumer opens a $1000 secured credit
account, the resulting credit report will make it appear that someone has
trusted that consumer enough to extend him or her credit, and increase your
capacity by $1000.
Pay down the sum of all balances so that you are using the least total capacity.
Using 30% of your capacity will trigger a reduction in score. 50% is more
severe, and can cause a drop of over 10 points. 75% is a major red flag.
Pay down each individual balance. It may make sense to move balances between
cards so no single balance is at more than 30% of its capacity. The 30% line may
be difficult to reach -- try to increase credit limits, or at least reduce card
balances to less than 75% of capacity. This contradicts the advice many credit
companies give when trying to get new customers to transfer balances, managing
line usage below these thresholds will lead to a higher score than consolidating
everything into one credit line and maxing it out. This will require more bills
to be paid each month, so requires extra work on the part of the consumer.
During mortgage refinances, you may be able to move some credit card debt to
your home loan, sometimes by withdrawing equity.
Keep an eye on how student loans are reported. Student loans are notorious for
being reported multiple times, making it look like one's monthly payment
obligations are higher than they actually are. This can both help and hurt -- a
credit report will show more obligations, but if these loans are in good
standing, you will show a good repayment history. If a loan is reported as paid
late multiple times, make sure to remove the duplication.
Establishing credit history
Trying to get rent and utility payments factored into one's credit score as
nontraditional credit if the person otherwise has no established credit.
Becoming an authorized signatory on one or more of one's parents' credit cards
that they carry a balance on. If the parents pay it responsibly, the authorized
signatory's credit score will benefit, whether he personally charges anything to
the card or not. This tip is especially useful for young adults with little or
no established credit. According to Suze Orman, if you join an account that has
been open for 10 years, your report inherits the full history of that account.
Trying to maintain at least a minimal amount of credit activity, because it has
been shown that consumers who maintain a minimal amount of credit are less
likely to default on a new account than consumers who don't maintain credit.
Minimizing damage in difficult times
Negotiate with your creditors. Discuss your situation and express willingness to
pay. If you can commit to a firm repayment schedule, creditors may be willing to
skip reporting any delinquency.
Paying the higher payment if a cash crunch makes it necessary to choose between
paying two bills. For example, if an $800 house payment and a $300 car payment
are due, and the person can only lay hands on $800, it will work out better for
their credit score if they pay the house payment.
Avoiding bankruptcy, since that will be a derogatory item in the credit report
that lasts for years. Anything is better for one's credit score than bankruptcy
– even working with a credit counseling service to get everything paid down.
Limit credit inquiries
Avoid causing inquiries to be posted to one's credit report. Credit score is
affected by recent inquiries made against one's credit report for the purpose of
evaluating an applicant for creditworthiness, including insurance. The credit
score is not affected by obtaining a copy of one's own credit report, nor by
"promotional" inquiries made by direct marketers such as credit card companies
who send out prescreened direct mail offers, nor by "account review" inquiries
made periodically by your own financial institution to manage the ongoing risk
of your account. Only the action of applying for new credit or insurance creates
a "hard" inquiry on one's credit report that affects the score. This typically
drops a FICO score by roughly 5 points, which remains for as much as two years.
When applying for credit, refuse to allow the creditor to check your credit
until the latest possible stage of your transaction. While shopping for a
mortgage, generate your own FICO score and use that score in discussions.