Tuesday, September 25, 2007

What is a Credit Score and How Does It Work?

Below are excerpts from a WSJ article that discusses how the basic FICO or credit score works. Having built credit scores a decade ago and worked with credit scores much of career as I designed underwriting systems, I found this article to be a good basic description of the subject. Based in the questions I have received from family and friends over the years, I would have to say that the subject of credit scores is more poorly understood than anything else.

. . . . Most consumers don't know their numbers until they apply for loans. Scores typically range from 300 points to 850 points.
Fair Isaac Corp. developed the FICO credit score, used by more than 90% of the largest lenders. About 40% of the population has a FICO score of 750 or higher; 18% has a 700-749 score; 27% has a score between 600 and 699, and 15% has a score below 600.

The score doesn't include a person's savings history or income. It varies depending on whether it comes from Fair Isaac or from one of the three largest credit reporting bureaus -- Equifax, Experian and TransUnion. . . . . The scores vary because not every credit reporting bureau has exactly the same information. This occurs becasue credit bureaus tend to be concentrated in certain geographic locations so the bureaus vary accordingly. (my comment)

. . . . However, about 35% of the score comes from payment history. That includes whether a person pays on time, and the presence of adverse records like a lien or bankruptcy, says Craig Watts, a Fair Isaac spokesman.

An additional 30% of the score is based on the amount owed, says Mr. Watts. Someone who has borrowed the maximum on a credit card will get a lower score than someone carrying a debt of less than half of what is available on the card. In the business this is called utilization. (my comment) A further 15% comes from a person's credit history. In the business this is called depth of file. (my comment) The older the accounts, the better. An additional 10% is based on the type of credit on record, and the final 10% comes from the number of recently opened accounts and credit inquiries. More inquiries is worse than less (my comment).

Missing even a single payment could cost 100 points. Consumers can raise their scores by paying bills on time, not borrowing to the limit on credit cards, and paying off debt.

Until this summer's subprime crisis, a score of 720 or higher earned you some of the best interest rates, says John Ventura, director of the Texas Consumer Complaint Center at the University of Houston Law School. Borrowers now need a score in the high 700s to get the same benefits, he says.

Getting the best rates could save thousands of dollars. A report released in July by the Consumer Federation of America and Washington Mutual Inc. found that if consumers with an average score increased their score by only 30 points, they would save $76 a year in finance charges. If all consumers raised their scores by 30 points, there would be $20 billion in savings.

The benefits are dramatic for mortgages. Raising a score from a range of 580-619 to 660-699 could save someone with a 30-year, $300,000 fixed mortgage $5,148 in one year, according to Fair Isaac's Web site (

Consumers shouldn't cancel old cards that they don't use, because "closing an account eliminates a positive reference," says Steven Katz, a spokesman for TransUnion.

If you plan to apply for credit in the near future, experts advise, don't use a credit card to pay for groceries and other purchases. Credit-rating companies see only the balance on the day they check.

Consumer groups recommend getting your score and a credit report at least once a year, more often if there is any possibility that you have been a victim of identity theft.

The reports are available free once a year from each of the three major reporting agencies and for a fee more often. Consumers must use the Web site
www.annualcreditreport.com rather than the individual Web sites to get the free reports.

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