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Credit Scoring - How lenders evaluate your credit
by Gary Foreman |
Let's see if we can't learn
something about the main tool that lenders use to decide whether to loan you money.
We'll begin our study with something called "credit scoring." It's a
mathematical score of your credit worthiness. The idea has been around since the 1950s.
The company that started the concept (Fair, Isaac Co.) describes the credit score as
"the quickest, most accurate and consistent way of determining the likelihood that
credit users will pay their bills."
The score is also commonly referred to as a FICO score (named after Fair, Isaac Co.). Your
FICO score will be between 375 and 900 points. A higher score indicates a better candidate
for credit. Typically 650 and above will put you in a good position to obtain new credit.
The score is calculated based on a mathematical model using up to 33 different factors
about your history. The formula is proprietary and and Fair, Isaac will not release it. In
fact, there's more than one formula. Different credit reporting agencies and lenders have
customized variations. So you don't really have just one score. You have many scores.
Ok, so what goes into the score? The different factors fall into five groups. The first is
your payment history: how good you've been about keeping up with your payments. Any late
payments or charge- offs are also considered. Remember that this isn't a all-or-nothing
deal. So one missed payment doesn't doom you to a low score. But a pattern of late charges
will certainly hurt.
Next the model will consider your outstanding debt. How many accounts are open and how
much debt you have? You can have too few accounts. The model seems to give you the highest
score if you have some credit, but not too much. Having one or two open accounts that are
fully paid off each month will actually help your score.
The model also considers your credit history. You get more points if you've had an account
for a longer period of time. The theory is that if you've been consistent over a number of
years, you're more likely to continue responsible behavior.
The pursuit of new credit can be a potential minefield to your score. The model considers
how many new accounts you've opened. But, more than that, it also looks at how many times
you've asked for credit.
Now this is where it can get interesting. The model doesn't always know why new requests
for credit are coming in under your name. Suppose you're out shopping for a new car and
visit a number of dealers. Let's further suppose that you ask them to find the best rate
for a car loan. Depending on how they get the information, it's possible that they can
generate a number of new queries on your credit. All those queries can actually lower your
score by making it look like you're out there trying to get a bunch of new credit.
Finally, the formula includes the types of credit in use. You'll receive a higher score
for home and auto loans than for bank and store credit cards. And installment loans will
likely count against you.
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