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How does credit scoring work?

 

Credit Scoring is a means of evaluating an individual’s credit using a very sophisticated scoring process. It was developed as part of a project involving two companies, TRW (now called Experian) and Fair, Isaac and Company (FICO). Their goal was to establish a system that would predict delinquency rates on loans. It’s important to understand that a credit score is designed to predict the likelihood of an individual falling 90 days delinquent on any account within the next 24 months. This definition is critical in understanding why certain actions may hurt or help your score.

 

One myth to debunk right up front is that all credit reports and the subsequent credit scores are the same.

They are not! All three credit bureaus have separate but similar credit scoring methods. You may find credit scores using the FICO (Experian), Beacon (Equifax), or Classic (Trans Union) methods. Also, the models are constantly being refined and improved resulting in different versions. The scores typically range from 300 to 850 depending on which credit bureau is utilized. The better the credit – the higher the score or, by definition, less likely that someone is going to fall 90 days delinquent on an account in the next 24 months.

 

There is a push to standardize the scoring modeling under one method. The most well known of these revised methods is the Vantage scoring model. Most credit decisions today are based on computer models that render decisions based on a number of criteria. Since most lenders have already built their decision process using one or more of the existing credit scoring models, getting them to retool their systems is unlikely due to cost and complexity.

 

Frequently customers come to me with a credit report that they obtained themselves only to find that when I run the credit report for the mortgage, the scores are very different. This is a result of the different versions issue plus the different scoring methods used by the different services and companies. Lending institutions of all types and insurance companies are just two of many industries that make business decisions based on your credit score. The scores generated for your mortgage may be different from that of your insurance company. The scoring methods can be adjusted for different industries as each of those industries may weigh the data differently.

 

Mortgage lenders have established a direct correlation between credit scores and delinquency rates. We know that a mortgage with a score in the mid-to-high 700’s has a very small likelihood of becoming delinquent while a score in the upper 500’s has a relatively good chance of encountering delinquencies. In the Detroit area the average credit score is about 675. There are 5 minimum criteria required to obtain a credit score. They are:

 

  • One tradeline opened for at least 6 months.
  • One tradeline must have been updated in the last 6 months.
  • The social security number not on the death master list.
  • The customer is not on the terrorist list.
  • No fraudulent activity is associated with the social security number.

 

Credit scoring does NOT include an individual’s sex, age, race, income, assets, marital status, employment, or residency. Other bills such as utility bills, insurances, rent, and medical bills will normally not reflect on your credit report unless they have become delinquent and resulted in a collection account or judgment. If it’s not on the credit report, it doesn’t count in credit scoring. The one exception that we see in the Michigan market is that DTE reports to the credit bureaus and subsequently can influence credit scores.

 

The developers of the credit scoring model analyzed the credit patterns of the profiles they were working with and came up with forty characteristics that are considered in credit scoring. Again, they were looking for those things that increased the likelihood of a 90 day delinquency in the next two years. We will talk about these 40 characteristics in broad terms below.

Your credit score is made up of five different components:

 

  • Payment History (35%)
  • Balances or credit usage (30%)
  • Credit History – not “Payment History” – (15%)
  • Type of Credit – (10%)
  • Inquiries (10%)

 

About 35% of your score is determined by your payment history. Derogatory information such as late payments and collection accounts are examples of events that can adversely affect your credit score. The assumption in credit scoring is that if you are already late on something, then the likelihood is strong that something else will end up late as well. Late payments that affect scores are those that are more than 30 days past due. In line with that, a 90 day late payment is going to affect the score more negatively than a 30 day late payment. Also, a recent late payment will lower your score much more than a late payment that took place long ago. As far as credit scoring is concerned, the type of account that was late is not important. Therefore a late payment on your house is scored the same way as a late payment on your Visa. (Keep in mind that your lender may not share that same sentiment and may analyze your credit further to see that late payments on loans similar to the one you are attempting to take out have occurred and may turn you down on that basis.) Typically, the time frames where late payments influence your credit score are at 6 months, 24 months and 48 months. That is, late payments within the last 6 months seriously impact your credit score, From 7 to 24 months the late payments still affect the score but not as much as during the first 6 months. The same for 24-48 months. After 48 months, the late payment has a much lesser affect, if any, on your score.

 

We will talk about major credit issues called “public records” such as judgments, bankruptcy, tax liens, and foreclosures later in this article.

 

Information such as late payments continue to show on your credit report for 7 years while more serious derogatory information such as bankruptcy and foreclosure can show for 10 years. You can see that a lot of information can be stored on your credit report. Some items can show as long as 12 years. In addition to derogatory information, how you use your credit impacts on your credit score. Up to 30% of your score is based on your outstanding debt. There are two ways of viewing your credit usage and both are based on percentages – not dollar amounts. The thresholds where your balances impact your score are 50% and 75%. These percentages are applied against both what percentage you owe on any single line of credit and the percentage you owe on all of your revolving debts combined. The more important of the two analyses is how much you owe on all of your accounts as a percentage of the available credit on all your accounts.

 

The neat thing is that credit scoring doesn’t have a memory as it pertains to usage. Therefore, paying down accounts or rearranging balances can have an almost immediate impact on your credit score. If you tend to use one or two cards exclusively and run them up to the limit, you may find your scores lower than if you spread out your balances over several cards so that all of them are under 50% of the balance. This can help increase your score.

 

Revolving debt will impact your credit scores more than installment debt. In fact, installment loan balances have a relatively small affect on your score unless you have little or no revolving accounts. Note that a credit card with a limit of $20,000 and a balance of $19,000 will hurt your score much more than a car loan of $20,000 and a balance of $19,000. Also, home equity lines with large balances (approximately $32-35,000) are normally scored as installment loans.

 

Your credit history, that is the length of time you have had credit, makes up about 15% of your credit score. It’s based on the average age of your cumulative credit cards. With this in mind you can see that sometimes it may be better for your credit score to negotiate with your old existing creditor for a lower rate than to open up new accounts. That way your average age stays higher because there aren’t a lot of new open cards to lower the average.

 

10% of your score comes from the type of credit you have. There are several ways of applying this against your credit score but some quick points may be better. First, too many (opened or closed) accounts can negatively impact your score. Second, finance company loans (HFC, Beneficial, etc) can lower your score. Third, bank cards such as MasterCard and Visa hold more weight than store cards like Sears or Kohl’s. Remember, this isn’t the same as late payments where all reported late payments count equally.

 

Some types of credit inquiries can influence your credit score and make up 10% of your credit score. Only the past 12 months’ worth of inquiries affect your score. A few inquiries into your credit are usually not going to impact it much and 5-7 are normally allowed without serious consequences. However, multiple inquiries can drive your score down. Typically each inquiry will drop your score 5-15 points. If you do the math you can also see that since this area only makes up 10% of your score, the most you should drop from inquires is 85 points and that would be if you had the highest score possible (850) to start with. People get pretty worried about inquiries but the impact is limited to 10% of the score and they don’t have the huge impact that people think.

 

Not all inquiries count against you though. “Soft” inquiries such as unsolicited offers of credit, employment checks, and insurance company inquiries don’t affect the score. Inquires derived from some action on your part such as responding to the offer in the mail or proactively applying for a loan count as a “hard” inquiry and can impact your score. Certain industries such as mortgages and automobile financing allow for unlimited inquiries within a 45 day window while still counting as only one inquiry. These are called “like” inquiries. There are also provisions where the inquiry won’t impact your score for 30 days form the first check. This allows you to shop for the big ticket items like a car or a house and not be penalized for shopping around.

NOTE – if you pull your own credit score and pay the fee, that does NOT count as an inquiry at all.

 

One of the most misunderstood components of credit scoring is when the individual has something showing in the public records. These would be items such as bankruptcy, judgments, tax liens, foreclosure, etc. When this occurs, the scoring method for these customers changes dramatically and most of what we have discussed no longer applies. For approximately 10 years after the public record there are three components that make up these individuals’ credit scores. The three things that control the customer’s score during that time are:

 

  • The % of tradelines included in the public record (i.e. bankruptcy).
  • The number of inquiries after the posting of the public record.
  • The payment record after the public record.

 

Many people attempt to secure new credit after an event such as a bankruptcy in order to re-establish their credit. Since one of the three things that impact credit scores for a person in the public records classification is inquiries, trying to build up new credit can have a detrimental effect on the credit score by resulting in too many inquiries. While the customer may be establishing new credit, that doesn’t mean that their credit score is increasing. In fact, it may in fact be dropping.

 

If you fall under the public records category as a result of a bankruptcy and have no outstanding credit from which to base a credit score or lending decision you may consider obtaining so-called “secured” credit cards. These are credit cards where the balance is determined by the amount that the customer has on deposit with the lender. This way the lender is guaranteed their money in the event the payment isn’t made. The advantage of these cards is that they usually report on the credit report the same way any other bank card shows but without the inquiry. One or two should do the trick of helping to re-establish your credit. Keep in mind though that these accounts can come with steep fees so shop and read the terms before you agree to the account. Also make sure that the provider of the secured card reports your payment information to the credit bureaus.

 

The old trick of getting added to another person’s account as an Authorized User is getting phased out by the credit bureaus. You aren’t able to count the good payment record of another person to help yours anymore. Some accounts may still reflect accounts as authorized users but this process is being eliminated from the credit scoring models.

 

Collection accounts are often misunderstood in credit scoring. For starters, the size or type of the collection account doesn’t matter – only the number of collection accounts. Also, the reported date of a collection account is critical. Credit scoring typically only recognizes collection accounts that are reported within the past 24 months. Therefore, old collection accounts do not impact your credit score after 2 years. In fact, paying off an old collection account runs the risk of updating the reporting date and causing that to drive down your score since you now have a collection account reporting within the past 24 months where before paying it off you didn’t. (I always get angry when I talk to a customer that was given advice from another loan officer that included paying off old collection accounts in the hope that it would improve their credit score. More than once I’ve seen it result in the scores actually dropping. You may be required to pay off a collection account to get a mortgage but it may be better to wait until after the lender runs the credit and determines the credit score. Always ask your lender what’s best to do.) If you wish to pay off an old collection account, you may consider requesting that one of the conditions of you paying the debt off is that the collection company delete the account completely from your credit report. Since most collection companies simply want the money and don’t care about your credit report, you may find them willing to comply with your request. As always – get it in writing first.

 

Divorces can wreak havoc on an individual’s credit score. For starters, when the court mandates that one party is responsible for a joint debt, that debt is NOT removed from the other party’s credit report. The court may require one party to pay the account but that doesn’t nullify the legal contract that the other party signed with the lender when taking out the loan. If the party to whom the court awarded the responsibility of the payments fails to make timely payments, it will reflect on the other party’s credit report just as if they were making late payments themselves. The only way to get the account off of someone’s credit report is with the approval of the lender or by paying off the account. There are a few things to keep in mind should you be in the position of going through a divorce.

 

Make sure that the divorce decree is very specific about all the open credit and who’s responsible for each joint account. I personally would even have the divorce papers reference them by account number or at least an abbreviated number. That way if the non-liable party decides that they want to secure a loan, the lender can at least reference the divorce decree and establish responsibility based on the divorce decree. Most lenders will not hold a person liable for a debt that has been awarded to an ex-spouse but they need to be sure that the accounts are the same ones.

 

Have all joint accounts closed to future use even if they are not paid off. I have had many customers with accounts on their credit report from ex-spouses that have been gone for years. Notify the creditor of your new contact information in the event they don’t receive a payment. That way you can be notified if the responsible party isn’t making the payments before it becomes a problem on your credit report.

 

You are allowed to submit a 100 word explanation to the credit bureaus explaining the debt and its status through the divorce. This won’t remove it but this will show up each time the credit report is run.

 

If your credit score is lower than you’d like, there are several things that you can do to improve it. First and foremost is to pay your bills on time. A pattern of late payments will continue to drive down your score. Many people think that having a lot of credit is a good thing and that is true to a certain extent. However, as in all things, moderation is the key. Since newly opened credit will lower your score, you will not want to open new credit if you are working on improving your score. At the same time, keep away from multiple inquiries. Resist the temptation to respond to all the offers you get in the mail. Always be sure to ask if the company you are speaking with is planning on running a credit report and how many.

Keep in mind that if the company doesn’t have your social security number they cannot run a credit check.

 

The next thing that you can do to improve your credit is to bring your balances down. Since credit cards with a large percentage of the available credit outstanding can lower your score, you may consider spreading the debt out amongst more than one credit card so that you are under the 50% / 75% ratios that I referenced earlier. Paying more than the minimums on credit cards will go a long way in helping bring down your balances as well as gradually improve your credit scores. You can also request that current credit card companies increase your limit. This may result in an inquiry but in the long run it may help as long as you don’t increase your balance! Most of all, don’t get suckered into paying hundreds of dollars to someone that claims to be able to fix your credit. At best that will only be a short term repair and much of the deleted items often come back. Just pay your bills on time.

 

Be sure to check your credit report for errors. I encounter many people who have incorrect information on their credit report that could have a bearing on their ability to obtain a loan or that negatively influences their credit score. Most of the online services to check credit are owned by one of the credit bureaus or are “for profit” companies. Consider using Annual Credit Report to check your credit once a year. This is the one official site for obtaining credit information and not being solicited for all sorts of services that cost you money.

 

Up until the mortgage crisis of 2007 there were high risk lenders that catered to people with low credit scores. Many of these high risk or “sub-prime” companies offered loans with higher interest rates, prepayment penalties, high fees, etc. Sometimes the lenders teased the customer with a low start rate to make it easier at the beginning of the mortgage. There were hidden charges and fees that didn’t show up until it was too late. Since the customer was often desperate, the lender often got away charging these additional fees or a higher rate. Too often the customer didn’t read or understand the terms of the loan they were getting. Many homeowners have lost and others are continuing to lose their homes after making timely payments simply because the interest rate skyrocketed and the payments got too high to make. Thankfully most of these companies are gone now. Investors finally cut off the money supply for these lenders and put them out of business.

 

The rate and terms on the mortgage you get will quite likely be influenced by your credit score. It’s very important to meet with a knowledgeable professional (like me!) who can evaluate your credit report and make suggestions on how to improve your scores. I often meet with people months before they buy a home so that they have time to take the steps necessary to improve their credit and secure better financing terms. I’ve been able to save people thousands of dollars in interest and fees with these preliminary reviews.

 

Despite the demise of the sub-prime mortgage industry, there are mortgages for people with “bumps and bruises” on their credit report. However, they are not as easy to get as the sub-prime loans were. You will be asked to explain the reasons for the difficulties and show how things have changed. You will also be required to re-establish a good payment record on your bills and to maintain timely payments. I often counsel with people that don’t qualify for a loan now and provide them with ways to improve their picture so that they can secure a loan in the future. I’ve found that often people just don’t know what lenders are looking for and I am able to educate them and prepare them for a home of their own. It’s not always easy and sometimes it takes a while but it can be done.

 

It can take a long time for your credit score to recover from a series of late payments or derogatory information. If you have corrected old mistakes or remedied old problems and have had a good payment record, you may qualify for one of several types of loans that are more flexible on credit scores. Loans such as FHA and VA are great loans that will look at your payment record over the past year or two and grant you a mortgage based on your payment history as opposed to your credit score. See my articles on FHA and VA for more information on these products.

Major Credit Bureaus

  • Equifax 800-685-1111
  • Experian 888-397-3742
  • Trans Union 800-916-8800