What is credit score?



Credit Score

A credit score is a number representing the creditworthiness of a person, the likelihood that person will pay his or her debts.

Lenders, such as banks, credit unions and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers. Widespread use of credit scores has made credit more widely available and cheaper for consumers. And because a score does not consider race, sex or ethnicity, it is generally considered to be the most fair and objective underwriting tool available to lenders.

FICO score and others

The best-known and most widely used credit score model is the FICO score that is calculated statistically, with information from a consumer’s credit files. It provides a snapshot of risk that banks and other institutions use to help make lending decisions. Applicants with higher FICO scores may be offered better interest rates on mortgages or automobile loans.

NextGen score – The NextGen Score is a scoring model designed by the FICO company for assessing consumer credit risk. It has not enjoyed the same level of adoption as the traditional FICO score.

VantageScore – In 2006, to try to win business from FICO, the three major credit-reporting agencies introduced VantageScore.

Others – Other credit consumer scores are published by third party agencies such as “Community Empower” and “Quizzle” as the CE Score. The scores reported by such agencies are NOT actual FICO scores, but approximations based on proprietary algorithms.


Makeup of the FICO score

Credit scores are designed to measure the risk of default by taking into account various factors in a person’s financial history. Although the exact formulas for calculating credit scores are secret, FICO has disclosed the following components:

  • 35% — Payment history – Late payments on bills, such as a mortgage, credit card or automobile loan, can cause a FICO score to drop. Paying bills on time will improve your FICO score.
  • 30% — Credit utilization – The ratio of current revolving debt (such as credit card balances) to the total available revolving credit or credit limit. You can improve your FICO scores by paying off debt and lowering the credit utilization ratio. Alternatively, applying for and receiving the credit limit increase will also drive down the utilization ratio. Closing of existing revolving accounts will typically adversely affect this ratio and therefore have a negative impact on their FICO score.
  • 15% — Length of credit history – As your credit history ages it can have a positive impact on their FICO score.
  • 10% — Types of credit used (installment, revolving, consumer finance, mortgage) – You can benefit by having a history of managing different types of credit.
  • 10% — Recent search for credit – Credit inquiries, which occur when you are seeking new credit, can hurt your score. Individuals shopping for a mortgage or auto loan over a short period will likely not experience a decrease in their scores as a result of these types of inquiries, however.

While all credit inquiries are recorded and displayed on your credit report for a period of time, credit inquiries that were made yourself (to check your credit), by your employer (for employee verification) or by companies initiating prescreened offers of credit or insurance do not have any impact on your credit score.

There are other special factors which can weigh on the FICO score. Any money owed because of a court judgment, tax lien, etc. carry an additional negative penalty, especially when recent. Having one or more consumer finance credit accounts may also be a negative.

FICO score range
A FICO score is between 300 and 850, exhibiting a left-skewed distribution with 60% of scores near the right between 650 and 799. According to FICO the median score is 723. Each individual actually has three credit scores for the FICO scoring model because the three national credit bureaus, Experian, Equifax and TransUnion, each has its own database. Data about an individual consumer can vary from bureau to bureau. These studies point out that people with higher scores have fewer claims. Studies also indicate that the majority of insureds pay less in insurance through the use of scores.

Criticism

Credit scores are widely used because they are cheap and reliable but do have their failings.

Easily gamed

Because a major portion of the FICO score is determined by the ratio of credit used to credit available, a simple way to increase the score is to simply increase the credit limit.[16] This practice is called authorized user account abuse. FICO developed a new version of the FICO score “FICO 08,” which FICO says should significantly limit the ability to tamper with the FICO score through authorized user abuse.

Source: http://en.wikipedia.org/wiki/Credit_score_(United_States)

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