What is credit scoring?
Credit scoring is a system creditors use to help determine whether to give
you credit or
credit cards.
Information about you and your credit experiences, such as your
bill-paying history, the number and type of accounts you have, late
payments, collection actions, outstanding debt, and the age of your
accounts, is collected from your credit application and your credit report.
Using a statistical program, creditors compare this information to the
credit performance of consumers with similar profiles. A credit scoring
system awards points for each factor that helps predict who is most likely
to repay a debt. A total number of points -- a credit score -- helps predict
how creditworthy you are, that is, how likely it is that you will repay a
loan and make the payments when due.
Because your credit report is an important part of many credit scoring
systems, it is very important to make sure it's accurate before you submit a
credit application. To get copies of your report, contact the three major
credit reporting agencies:
- Equifax: (800) 685-1111
- Experian (formerly TRW): (888) EXPERIAN (397-3742)
- Trans Union: (800) 916-8800
These agencies may charge you up to $8.50 for your credit report.
Why is credit scoring used?
Credit scoring is based on real data and statistics, so it usually is more
reliable than subjective or judgmental methods. It treats all applicants
objectively. Judgmental methods typically rely on criteria that are not
systematically tested and can vary when applied by different individuals.
How is a credit scoring model developed?
To develop a model, a creditor selects a random sample of its customers, or
a sample of similar customers if their sample is not large enough, and
analyzes it statistically to identify characteristics that relate to
creditworthiness. Then, each of these factors is assigned a weight based on
how strong a predictor it is of who would be a good credit risk. Each
creditor may use its own credit scoring model, different scoring models for
different types of credit, or a generic model developed by a credit scoring
company.
Under the Equal Credit Opportunity Act, a credit scoring system may not
use certain characteristics like -- race, sex, marital status, national
origin, or religion -- as factors. However, creditors are allowed to use age
in properly designed scoring systems. But any scoring system that includes
age must give equal treatment to elderly applicants.
What can I do to improve my score?
Credit scoring models are complex and often vary among creditors and for
different types of credit. If one factor changes, your score may change --
but improvement generally depends on how that factor relates to other
factors considered by the model. Only the creditor can explain what might
improve your score under the particular model used to evaluate your credit
application.
Nevertheless, scoring models generally evaluate the following types of
information in your credit report:
- Have you paid your bills on time?
Payment history typically is a
significant factor. It is likely that your score will be affected
negatively if you have paid bills late, had an account referred to
collections, or declared bankruptcy, if that history is reflected on your
credit report.
- What is your outstanding debt?
Many scoring models evaluate the
amount of debt you have compared to your credit limits. If the amount you
owe is close to your credit limit, that is likely to have a negative
effect on your score.
- How long is your credit history?
Generally, models consider the
length of your credit track record. An insufficient credit history may
have an effect on your score, but that can be offset by other factors,
such as timely payments and low balances.
- Have you applied for new credit recently?
Many scoring models
consider whether you have applied for credit recently by looking at
"inquiries" on your credit report when you apply for credit. If you have
applied for too many new accounts recently, that may negatively affect
your score. However, not all inquiries are counted. Inquiries by creditors
who are monitoring your account or looking at credit reports to make
"prescreened" credit offers are not counted.
- How many and what types of credit accounts do you have?
Although
it is generally good to have established credit accounts, too many credit
card accounts may have a negative effect on your score. In addition, many
models consider the type of credit accounts you have. For example, under
some scoring models, loans from finance companies may negatively affect
your credit score.
Scoring models may be based on more than just information in your credit
report. For example, the model may consider information from your credit
application as well: your job or occupation, length of employment, or
whether you own a home.
To improve your credit score under most models, concentrate on paying
your bills on time, paying down outstanding balances, and not taking on new
debt. It's likely to take some time to improve your score significantly.
How reliable is the credit scoring system?
Credit scoring systems enable creditors to evaluate millions of applicants
consistently and impartially on many different characteristics. But to be
statistically valid, credit scoring systems must be based on a big enough
sample. Remember that these systems generally vary from creditor to
creditor.
Although you may think such a system is arbitrary or impersonal, it can
help make decisions faster, more accurately, and more impartially than
individuals when it is properly designed. And many creditors design their
systems so that in marginal cases, applicants whose scores are not high
enough to pass easily or are low enough to fail absolutely are referred to a
credit manager who decides whether the company or lender will extend credit.
This may allow for discussion and negotiation between the credit manager and
the consumer.
What happens if you are denied credit or don't get the terms you want?
If you are denied credit, the Equal Credit Opportunity Act requires that the
creditor give you a notice that tells you the specific reasons your
application was rejected or the fact that you have the right to learn the
reasons if you ask within 60 days. Indefinite and vague reasons for denial
are illegal, so ask the creditor to be specific. Acceptable reasons include:
"Your income was low" or "You haven't been employed long enough."
Unacceptable reasons include: "You didn't meet our minimum standards" or
"You didn't receive enough points on our credit scoring system."
If a creditor says you were denied credit because you are too near your
credit limits on your charge cards or you have too many credit card
accounts, you may want to reapply after paying down your balances or closing
some accounts. Credit scoring systems consider updated information and
change over time.
Sometimes you can be denied credit because of information from a credit
report. If so, the Fair Credit Reporting Act requires the creditor to give
you the name, address and phone number of the credit reporting agency that
supplied the information. You should contact that agency to find out what
your report said. This information is free if you request it within 60 days
of being turned down for credit. The credit reporting agency can tell you
what's in your report, but only the creditor can tell you why your
application was denied.
If you've been denied credit, or didn't get the rate or credit terms you
want, ask the creditor if a credit scoring system was used. If so, ask what
characteristics or factors were used in that system, and the best ways to
improve your application. If you get credit, ask the creditor whether you
are getting the best rate and terms available and, if not, why. If you are
not offered the best rate available because of inaccuracies in your credit
report, be sure to dispute the inaccurate information in your credit report.
