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In the
United States, a credit score is a number
typically between 300 and 850, based on a
statistical analysis of a person's credit files,
to represent the
creditworthiness
of that person, which is the likelihood that the
person will pay his or her bills. A credit score
is primarily based on
credit report
information, typically from the three major
credit reporting agencies.
Lenders, such as
banks
and
credit card
companies, use credit scores to evaluate the
potential risk posed by lending money to consumers
and to mitigate losses due to
bad debt.
Lenders use credit scores to determine who
qualifies for a loan, at what
interest rate,
and what credit limits. The use of credit or
identity scoring prior to authorizing access or
granting credit is an implementation of a
trusted system.
While the most widely known score in the United
States is FICO (which is most widely used in the
mortgage industry), there are many others, such as
NextGen,
VantageScore
and the CE Score.
FICO
is an acronym for
Fair Isaac Corporation
and refers to the best-known credit score model in
the
United States.
The FICO score is calculated by applying
statistical methods, developed by Fair Isaac, to
information in one's credit file. The FICO score
is primarily used in the consumer banking and
credit industry. Banks and other institutions that
use scores as a factor in their lending decisions
may deny credit, charge higher
interest rates,
or require more extensive
income
and
asset
verification if the applicant's credit score is
low.
Credit
scores are designed to indicate the likelihood
that a borrower will default. No public
information is available to determine what the
scores mean in terms of statistics. A separate
score, BNI, is used to indicate likelihood of
bankruptcy.
Although Fair Isaac's Web site offers to sell
consumers their "FICO score," the company actually
uses slightly different scoring methods to rate a
consumer's suitability for three different types
of credit—mortgages, auto loans, and consumer
credit—reflecting the differing risks of these
various types of lending. It is not unusual for
these scores to differ by fifty points or more for
the same borrower. (The number offered to
consumers is the consumer credit score.)
In the
US, three major
credit reporting agencies
(often inaccurately called "credit bureaus"),
Equifax,
Experian
and
TransUnion,
also calculate their own credit scores. Scores,
many with trademarked names, differ by what they
are meant to predict, statistical methods used to
determine a score, as well as what information is
used and how it is weighted. For example, Beacon,
Beacon 5.0, Beacon 96, and Pinnacle scores are
available only from Equifax; Empirica, Empirica
Auto 95, Precision Score, and Precision 03 at
TransUnion; and Fair Isaac Risk Score at Experian.
While these versions are developed for the
agencies by Fair Isaac, they differ and are
periodically updated to reflect current consumer
repayment behavior. The NextGen Score is a scoring
model designed for consumers. Other consumer
scores are published by MyFICO.com and by
Community Empower
(the CE Score).
In
2006, in an attempt to make scoring more
consistent, the three major credit reporting
agencies introduced
VantageScore.
VantageScore uses a different range from FICO
(from 501 to 990) and also assigns letter grades
from A to F to specific ranges of scores. A
consumer's VantageScore may still differ from
agency to agency, but the discrepancies would be
entirely due to differences in the information
reported to the various agencies, not due to
differences in scoring models. Since FICO is still
widely used by lenders, the agencies continue to
offer FICO scores (or their closest equivalent) as
well.
Most
scores use a multiple-scorecard design. Each
version may use individual scorecards, and an
individual is typically compared with other
consumers. (For example, a borrower with two
30-day late payments will be scored against a
population with some similar delinquencies.) The
individual is then graded according to which
variables indicate a repayment risk in that group.
Nearly
all large banks also build and use their own
proprietary statistical models for credit scoring
purposes, often in conjunction with outside
scoring formulas.
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.
It 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 ("too many delinquencies
60 days or greater").
There
are 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.
For
ease of use, most scores are mathematically scaled
so that they fall in the same general range as
prominent scoring model competitors. Since Fair
Isaac provides the dominant scoring methodology,
non-Fair Isaac scores are often designed to mimic
FICO scores and are sometimes derisively referred
to as "FAKO" scores.
Fair
Isaac offers scoring models for the U.S., Canada,
and South Africa, and the firm also offers a
"Global FICO" for many other countries.
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 closely
guarded secrets, Fair Isaac has disclosed the
following components and the approximate weighted
contribution of each:
-
35%,
punctuality of payment in the past (only includes
payments later than 30 days past due)
-
30%,
the amount of debt, expressed as the ratio of
current revolving debt (credit card balances,
etc.) to total available revolving credit (credit
limits)
-
15%,
length of credit history
-
10%,
types of credit used (installment,
revolving,
consumer finance)
-
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 and the average length of time an account has
been open. Although only 35% is attributed to
punctuality, if a consumer is substantially late
on numerous accounts, his score will fall far more
than 35%.
Bankruptcies,
foreclosures,
and
judgments
affect scores substantially, but are not included
in the somewhat simplistic pie chart provided by
Fair Isaac.
Current income and employment history do not
influence the FICO score, but they are weighed
when applying for credit. For instance, an
unemployed individual with no other sources of
income 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 judgment, tax
lien, or similar carry an additional negative
penalty, especially when recent.
-
Having more than a certain number of
consumer finance
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 credit agencies usually
claim to allow for credit checks made within a
certain window of time to not aggregate, so as to
allow the consumer to shop around for rates.
A FICO
score generally ranges from 300 to 850. It
exhibits a
left-skewed distribution
with a
median
around 723. The performance of the scores is
monitored and the scores are periodically aligned
so that a credit grantor normally does not need to
be concerned about which score card was employed.
Each
individual actually has three credit scores for
any given scoring model because the three credit
agencies have their own, independent databases.
These databases are independent of each other and
may contain entirely different data. Many lenders
will check an applicant's score from each bureau
and use the median score to determine the
applicant's credit worthiness.
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