Picture this scenario. Two people walk into an electronics store and see the sweetest home theatre system, the sound is awesome, the picture is incredible, and better still, it is on sale. You need it bad. There are signs everywhere offering no money down, or no interest for 12 months. A sales clerk walks over to you and says, “We can get you approved right away.” You answer a few questions, and within minutes one of you is hauling a brand new home theatre system out to your car, while the other one goes home disappointed.
So, what just happened? How did they make the decision to approve one of you while the other one got turned down? Did someone in an office somewhere roll some dice to decide who gets credit? No, lenders like banks, credit unions, and finance companies use credit scoring system to make these decisions. This way they are able to evaluate millions of consumer applications quickly, consistently, and impartially, based on a variety of criteria.
Although it may seem arbitrary or impersonal, a properly developed credit scoring system can make decisions faster and more accurately than an individual can. Most lenders use a credit scoring system called a “FICO score.” This scoring system was developed by a company called Fair Isaacs Company (hence the name FICO) to predict the likelihood of a consumer paying their bills on time.
What is a FICO score?
A FICO score is a number between 300 and 850, with 300 being low and 850 being perfect. Since 60% of people score between 650 and 799, a high FICO score would be anything over about 750. Although they use the same scoring algorithm (mathematical formula), your actual credit score may be different with each credit bureau because the information they have on you might be different.
There are two other credit scoring systems, VantageScore and CE Score which have been introduced since 2006 in an attempt to take business away from the Fair Isaacs Company. These systems work basically the same way as the FICO score, but so far they have only managed to acquire a very small portion of the market.
FICO scores are based on the following factors:
35% of the score is based on your payment history
The importance of your credit history speaks for itself. Behavioral theory says that, given the same conditions, how you behaved in the past is a pretty good indicator of how you will behave in the future.
- Late payments cause your score to drop.
- Paying bills on time improves your score.
- Court judgments and tax liens really reduce your credit score, so negotiate with your creditors to avoid court judgments.
30% of the score is based on credit utilization
- How high is your balance in relation to the amount of available credit? In other words, are your credit cards all maxed out, or do you have more room available on your cards?
- Pay down debt to improve your score.
- It might sound contradictory, but getting a credit limit increase will also drive down your score.
- Closing any existing revolving accounts will cause your score to drop, so it is usually better to pay down an existing account but leave the account open.
15% of the score is based on the length of your credit history
- The longer your accounts have been opened and established the better.
- It takes time to develop a good credit history, it doesn’t happen overnight
10% of the score is based on the types of credit you have had
- Credit cards, bank loans, etc.
- Your score goes up if you have a history of managing different types of credit.
10% of the score is based on recent applications for credit
Any time a potential lender makes a credit inquiry about you it lowers your score slightly. Keep this in mind before you start applying for credit all over the place.
The exceptions to this are:
- If you make an inquiry to get your own score (a self-check).
- If an employer does a pre-employment screening check.
- If a company (such as an insurance company), pre-screens you as a potential client.
Credit scoring is based on volume
Credit scoring assumes that all customers with similar FICO score ranges will behave similarly when it comes to paying their bills on time. Of course, this is not always true on an individual basis, but with a large enough group of consumers, the individual differences balance out.
FICO scores can be used to increase sales or reduce credit risk
Each lender decides how it will incorporate credit scoring into its credit approval process. The importance it attributes to credit scores will depend on the lender’s tolerance for credit risk. Lenders regularly modify the “threshold” score at which they will approve a credit application.
If a lender wants to increase sales, they might decide to lower the approval threshold. If their original approval score was 740, anyone who scored above that number would automatically be approved, but then if they wanted more sales they might decrease the threshold score to 690. This increase in sales would, of course, result in a corresponding increase in credit risk.
But if a lender decides that they want to reduce credit risk they might choose to increase the threshold approval score. The higher threshold score will reduce sales by the increased amount of declined applications.
Some lenders still have a credit manager who has the authority to make a final decision whether or not to extend credit for applicants whose credit scores are close to the pass or fail mark.
A good credit score can save you money
Credit scoring is used for more than just accepting or declining credit applications. Credit scores can be tools used to decide what risk is associated with ranges of scores, and therefore, how much to charge for that risk.
Each applicant’s individual credit score will fall within a “risk” class. For example, if one customer scores lower than average, that customer’s profile is deemed to be less ideal because the risk of not paying on time is believed to be higher than the average. Higher risk classes of credit applicants (those with lower scores), will be charged a higher rate of interest to reflect the higher risk. The lender hopes that the increase in interest revenue will more than offset the increase in bad debt write-offs that will occur in the group whose credit score is lower. Therefore, if you have a higher score you will get a better interest rate which will save you money.
What is a “good” credit score?
There is no magic number. What is considered a good credit score varies from lender to lender, from time to time, and is influenced by market conditions outside of your control. Don’t get too wrapped up in the actual number. What matters is whether your score is high enough to allow you to have your credit request approved. Since most scores are between 650 and 799 the closer you can get to the top of the range the better.
Ideally, before you begin shopping for credit, get a copy of your own annual credit report from each of the three major credit bureaus (Equifax, Experian, and Transunion). Make sure that you get the score as well as the credit report. When you know what your score is you can ask various lenders what score is necessary to get approved by them at the present time. Bank lending officers will usually be able to tell you, but the average store clerk taking your credit application won’t have a clue what you are talking about.
You can’t change the past, but you can change your behavior now. How you handle your finances now will determine your credit score in the future.
