Credit Education

03. Aug, 2016

How Credit Scoring Works

At one time, lenders had to wade through a borrower’s credit report to work out if they were a good risk. Credit scores offer a quick, convenient shortcut to assess lending risks.

Everyone wants to know their credit score. For some people, it’s a measure of financial success. For others, this three digit figure brings aggravation. Potential lenders also take a keen interest in credit scores. The world of finance uses credit scores as a measure of borrower trustworthiness. A customer with a high score qualifies for the red carpet treatment. The customer with a low score receives a cold rejection. Many institutions refuse to open or extend a credit line, and any loan offers come with high interest rates and other unfavorable terms.

Credit scores certainly matter. People even hire credit repair services to boost their credit score. Despite all this interest, not many people understand how credit scores are calculated. Some even suspect discrimination on grounds of race or color. While nobody with a high credit score seems to complain, low scorers often wonder why they receive such a bad credit rating. In every system, mistakes are possible. However, the credit score formula still seems to be fairer than the alternatives. These instant measures of credit status remove the need for time-consuming individual credit checks. When the credit score gives the lender information they need, they are unlikely to let personal prejudices affect their decision.  

Credit Score Calculations
Credit bureaus calculate credit scores with special software. They only use credit history details in these calculations. Credit records include legal judgments made against the customer for bankruptcy or loan defaults. Details of ethnic background, nationality, and similar person details play no part in credit score calculations. In the USA, most lenders use the FICO (Fair Isaac Corporation) credit score scale. Credit bureaus use credit history data from customer credit reports to set FICO scores. These scores range from 300 to 850 points. The higher the FICO score, the better the customer’s credit..

What Influences FICO Credit Scores?
FICO describes how various credit history items affect the customer’s score.

Prompt loan payments are one of the most important parts of the FICO score equation. The customer’s credit payment record accounts for 35% of their credit score. This means that a customer with a long list of loan defaults and late payments could push down their FICO score below 600. Before the bureau even starts to consider their other financial dealings, they earn a bad credit rating!

Amounts owed to creditors provide the second most important influence on credit scores. This credit history item helps determine 30% of the score. The customer’s debts don’t automatically bring  a higher risk borrowing status. Their credit score might not go down if they owe large sums but pay promptly and have much more credit available.

The length of the customer’s credit history also affects the credit store. FICO say that this factor accounts for 15% of the credit score. As a rule, credit bureaus like to see long credit histories. This allows them to make more accurate assessments of the customer’s financial dealings. This might work against young people who have just entered the labor market. However, if the rest of their credit report is fine, the short credit history should not lower their credit score.

Ten percent of the credit score reflects the mixture of credit in the customer’s history. As a rule, the more credit options and credit amounts available, the higher the credit score.

New credit lines influence another ten percent of FICO scoring. Customers who open a few new credit lines in a short time raise the risk level. Higher risk level lowers credit scores.

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