For years lenders have used credit scoring systems to find out whether a borrower is a good risk for a mortgage, a car loan, or a credit card. The three-digit credit score is more than just a score card, it determines the amount of interest you have to pay. A low credit score can cost thousands of dollars in additional interest while consumers with very poor credit scores may be denied credit.
The credit scoring system can be complex and various companies have developed their own systems to determine the financial capacity of a person. All these models have some similarities in the sense that they include the following factors:
Payment History – Prompt payments are an important consideration for all lenders, so they take the consumer’s payment history seriously. If a person declares bankruptcy or if they own an account that has been referred to collections, they will have a lower credit score.
Outstanding Debt – Most scoring models compare how much is owned compared to the credit limit. It is never wise to max out the credit card limit. Paying off the credit card debt each month may help a person avoid additional interest payments, but it does not necessarily add to they credit score. The reason is that the reports reflect your credit score on a certain day. If it is scored before the credit card bill is paid in full, the high balance may be displayed as debt.
Length of Credit History – The total length of time that was tracked by the credit report will affect a consumer’s score. A short or insufficient credit history might reflect negatively on the total credit score. Conversely, a long history of good credit will reflect positively on the credit score.
New Credit Applications – Applying for too many new credit accounts can be damaging to the credit score. If the consumer has been denied credit by any banking institution, it will be displayed on his credit report.
Types of Credit – Bank credit cards with good payments will reflect more positively on the credit score compared to a department store card. Prompt mortgage and car loan payments have a significant positive effect as well.
There are two major types of credit scoring models: the FICO score and the VantageScore. Currently, the FICO scoring system, which is developed by Fair Isaac Inc, is the most common. FICO scores range from 300 to 850. Scores that are under 620 are considered “subprime.” Though the exact formula of the FICO score is confidential, Fair Isaac has divulged five criteria with its relative weight:
Payment History – 35%
Amounts Owed – 30%
Length of Credit History – 15%
New Credit – 10%
Types of Credit – 10%
Recent trends reveal that credit scores are now being used outside loan applications. Employers are now turning to credit scores when evaluating potential hires. In addition, having a poor credit rating can disqualify a person from government security clearance. Even insurance companies are using this information to determine whether to set premium costs for their clients. State laws prohibit insurance companies from using the credit score to cancel an existing policy.
