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Credit score in the United States

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A credit score in the United States is a number representing the creditworthiness of a person, the likelihood that person will pay his or her debts.

Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers. Widespread use of credit scores has made credit more widely available and less expensive for many consumers.[1][2]

Credit scoring models

FICO score

The FICO score is the best-known and most widely used credit score model in the United States. It was first introduced in 1989 by FICO, then called Fair, Isaac, and Company. The FICO model is used by the vast majority of banks and credit grantors, and is based on consumer credit files of the three national credit bureaus: Experian, Equifax, and TransUnion. Because a consumer's credit file may contain different information at each of the bureaus, FICO scores can vary depending on which bureau provides the information to FICO to generate the score.

Makeup of the FICO score

The approximate makeup of the FICO score used by US lenders

Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history. Although the exact formulas for calculating credit scores are secret, FICO has disclosed the following components:[3][4]

  • 35%: Payment history—Late payments on bills, such as a mortgage, credit card or automobile loan, will cause a FICO score to drop.[5] Bills paid on time will improve a FICO score.[6]
  • 30%: Credit utilization—The ratio of current revolving debt (such as credit card balances) to the total available revolving credit or credit limit. FICO scores can be improved by paying off debt and lowering the credit utilization ratio.[7] Alternatively, applications for and receiving the credit limit increase will also drive down the utilization ratio. Alternatively, opening new lines of credit will have the same effect (keep in mind the "Average age of tradelines" and "Hard inquiries" matrices on the last possibility). The closing of existing revolving accounts will typically adversely affect this ratio and therefore have an adverse impact on a FICO score.
  • 15%: Length of credit history—As a credit history ages it can have a positive impact on its FICO score.[8]
  • 10%: Types of credit used (installment, revolving, consumer finance, mortgage)—Consumers can benefit by having a history of managing different types of credit.[9]
  • 10%: Recent searches for credit—hard credit inquiries, which occur when consumers apply for a credit card or loan (revolving or otherwise), can hurt scores, especially if done in great numbers. Individuals who are "rate shopping" for a mortgage, auto loan or student loan over a short period (a fortnight or 45 days, depending on the generation of FICO score used) will likely not experience a meaningful decrease in their scores as a result of these types of inquiries, as the FICO scoring model considers all of those types of hard inquiries that occur within 14 or 45 days of each other as only one. Further, mortgage, auto and student loan inquiries do not count at all in your FICO score if they are less than 30 days old. While all credit inquiries are recorded and displayed on personal credit reports for two years they have no effect after the first year because FICO's scoring system ignore them after 12 months. Credit inquiries that were made by the consumer (such as pulling a credit report for personal use), by an employer (for employee verification) or by companies initiating pre-screened offers of credit or insurance do not have any impact on a credit score: these are called "soft inquiries" or "soft pulls", and do not appear on a credit report used by lenders, only on personal reports. Soft inquires are not considered by credit scoring systems.

Getting a higher credit limit can help your credit score. The higher the credit limit on the credit card, the lower the utilization ratio average for all of your credit card accounts. The utilization ratio is the amount owed divided by the amount extended by the creditor and the lower it is the better your FICO rating, in general. So if you have one credit card with a used balance of $500 and a limit of $1,000 as well as another with a used balance of $700 and $2,000 limit; the average ratio is 40 percent ($1,200 total used divided by $3,000 total limits). If the first credit card company raises the limit to $2,000; the ratio lowers to 30 percent; which could boost the FICO rating.

There are other special factors which can weigh on the FICO score.

  • Any money owed because of a court judgment, tax lien, etc. carry an additional negative penalty, especially when recent.
  • Having one or more newly opened consumer finance credit accounts may also be a negative.[10]

FICO score ranges

There are several types of FICO score: generic or classic, bankcard, personal finance, mortgage, installment loan, auto, and NextGen score. The generic or classic FICO score is between 300 and 850, and 37.2% of people had between 750 and 850 in 2012.[11] According to FICO, the median FICO score in 2006 was 723, and 711 in 2011.[12] The FICO bankcard score and FICO auto score are between 250 and 900. The FICO mortgage score is between 300 and 850. Higher scores indicate lower credit risk.

Each individual actually has 49 credit scores for the FICO scoring model because each of three national credit bureaus, Equifax, Experian and TransUnion, has its own database. Data about an individual consumer can vary from bureau to bureau. FICO scores have different names at each of the different credit reporting agencies: Equifax (BEACON), TransUnion (FICO Risk Score, Classic) and Experian (Experian/FICO Risk Model). There are three active generations of FICO scores: 1998, 2004, and 2008 (FICO 8). Consumers can get their generic FICO score for Equifax (version of 2004), TransUnion (version of 1998), and Experian (version of 2008) from the FICO website (myFICO), and also their generic FICO score for Equifax (named Score Power) in the website of this credit bureau. Other types of FICO scores cannot be obtained by consumers. Some credit cards offer a free monthly FICO score to their cardholders.

FICO NextGen Risk Score

The NextGen Score is a scoring model designed by the FICO company for assessing consumer credit risk. This score was introduced in 2001, in 2003 the second generation of NextGen was released.[citation needed] In 2004, FICO research showed a 4.4% increase in the number of accounts above cutoff while simultaneously showing a decrease in the number of bad, charge-off and Bankrupt accounts when compared to FICO traditional.[13] FICO NextGen score is between 150 and 950.

Each of the major credit agencies market this score generated with their data differently:

  • Experian: FICO Advanced Risk Score
  • Equifax: Pinnacle
  • TransUnion: FICO Risk Score NextGen ( formerly Precision )

Prior to the introduction of NextGen, their FICO scores were marketed under different names:

  • Experian: FICO risk model
  • Equifax: BEACON
  • TransUnion: FICO Risk Score, Classic (formerly EMPIRICA)

VantageScore

In 2006, to try to win business from FICO, the three major credit-reporting agencies introduced VantageScore. According to court documents filed in the FICO v. VantageScore federal lawsuit the VantageScore market share was less than 6% in 2006. The VantageScore score methodology initially produced a score range from 501–990, but VantageScore 3.0 adopted the score range of 300-850 in 2013.[14] Consumers can get their VantageScores for Experian and TransUnion from their respective websites, and their VantageScore for Equifax from Quizzle.

CE Score

CE Score is published by CE Analytics and licensed to sites like Community Empower and iQualifier.com. This score is distributed to 6,500 lenders through the Credit Plus network but is free to consumers. It has a range of 350 to 850.[15][16]

Other credit scores

The non-FICO scores are called FAKO scores by some consumers. Experian has a credit score for educational use only (Plus Score) between 330 and 830, and Experian Scorex PLUS score is between 300 and 900. Equifax has the Equifax Credit Score between 280 and 850. Some lenders use an Application Score between 100 and 990, and Credit Optics Score by ID Analytics Inc. between 1 and 999. TransUnion's TransRisk New Account Score in the website Credit Karma is between 300 and 850, and Experian National Equivalency Score in Credit Sesame and Credit.com ranges from 360 to 840. Several websites (TransUnion, Equifax, Experian, Credit Karma, Credit Sesame etc.) offer different credit scores to consumers, but not used by lenders. Innovis and PRBC are other companies that produce credit scores used by some lenders.

Free annual credit report

Main article: Comparison of free credit report websites

As a result of the FACT Act (Fair and Accurate Credit Transactions Act), each legal U.S. resident is entitled to a free copy of his or her credit report from each credit reporting agency once every twelve months.[17] The law requires all three agencies to provide reports: Equifax, Experian, and Transunion. These credit reports do not contain credit scores from any of the three agencies.

Non-traditional uses of credit scores

Main article: Insurance score

Credit scores are often used in determining prices for auto and homeowner's insurance. Starting in the 1990s, the national credit reporting agencies that generate credit scores have also been generating more specialized insurance scores, which insurance companies then use to rate the insurance risk of potential customers.[18][19] Studies indicate that the majority of insureds pay less in insurance through the use of scores.[20][21] These studies point out that people with higher scores have fewer claims.

In 2009, TransUnion representatives testified before the Connecticut legislature about their practice of marketing credit score reports to employers for use in the hiring process. Legislators in at least twelve states introduced bills, and three states have passed laws to limit the use of credit check during the hiring process.[22]

Criticism

Credit scores are widely used because they are inexpensive and largely reliable, but do have their failings.

Easily gamed

Because a significant portion of the FICO score is determined by the ratio of credit used to credit available on credit card accounts, one way to increase the score is to increase the credit limits on one's credit card accounts.[23]

Not a good predictor of risk

Some have blamed lenders for inappropriately approving loans for subprime applicants, despite signs that people with poor scores were at high risk for not repaying the loan. By not considering whether the person could afford the payments if they were to increase in the future, many of these loans may have put the borrowers at risk for default.[24]

According to a Fitch study, the accuracy of FICO in predicting delinquency has diminished in recent years. In 2001 there was an average 31-point difference in the FICO score between borrowers who had defaulted and those who paid on time. By 2006 the difference was only 10 points.

Some banks have reduced their reliance on FICO scoring. For example, Golden West Financial (which merged with Wachovia Bank in 2006) abandoned FICO scores for a more costly analysis of a potential borrower's assets and employment before giving a loan.[23]

Use in employment decisions

Experian, Equifax, TransUnion and their trade association (the Consumer Data Industry Association or "CDIA") have all gone on record time and time again saying that employers do not receive credit scores on the credit reports sold for the purposes of employment screening. The use of credit reports for employment screening is allowed in all states although some have passed legislation limiting the practice to only certain positions.

Other concerns

The use of credit information in connection to applying for various types of insurance or in landlord background checks have drawn similar amounts of scrutiny and criticism. This is because the activities of finding secure employment, renting suitable accommodation and securing insurance are the basic functions of meaningful participation in modern society, and in the case of some types of auto insurance for instance, are mandated by law.[25]

See also

References

  1. ^ Report to the Congress on credit scoring and its effects on the availability and affordability of credit
  2. ^ An overview of consumer data and credit reporting
  3. ^ "How Are Credit Scores Calculated? Learn What Affects Your Credit Score". myFICO.com. Retrieved 2010-01-19.
  4. ^ Dayana Yochim. "How Lenders Keep Score". TheMotleyFool. Retrieved 2008-02-29.
  5. ^ Up to about 60 points for one sixty-day late on a 720 base score.
  6. ^ 3. Pay on time – How to be a savvy credit cardholder(Aug. 27, 2008)Bankrate, Inc
  7. ^ Here's how you can shape up your credit score Sandra Block (1/29/2008)Your Money columns, USA TODAY
  8. ^ The Real Estate Wonk: How-to Monday: Credit scores – reporter Jamie Smith Hopkins – Baltimore Sun
  9. ^ Is Paying Off the Mortgage Good for Our Credit? CREDIT CARDS Q&A By Joan Goldwasser, Kiplinger Personal Finance magazine, October 2008
  10. ^ "Hold Off on Opening New Credit Cards" 12–09–07
  11. ^ Credit Score Information: About FICO Scores – myFICO.com
  12. ^ "New Mortgages Worry Regulators" The Washington Post, June 10, 2006
  13. ^ "FICO NextGen Score". FICO.
  14. ^ "VantageScore". VantageScore.com. Retrieved 2010-01-19.
  15. ^ "How to get a free credit score". Bankrate.com. Retrieved 2011-06-26.
  16. ^ "What kind of credit score does Quizzle offer?". Quizzle. Retrieved 2011-06-26.
  17. ^ https://www.annualcreditreport.com/cra/helpfaq#creditfile
  18. ^ Credit-based insurance scores: Impacts on consumers of automobile insurance A Report to Congress by the Federal Trade Commission July 2007
  19. ^ No evidence of disparate impact in Texas due to use of credit information by personal lines insurers Dr. Robert P. Hartwig in January, 2005. Insurance Information Institute
  20. ^ Allstate Insurance Company’s additional written testimony July 23, 2002
  21. ^ Use and impact of credit in personal lines insurance premiums pursuant to Ark. code Ann. §23-67-415 (September 1, 2006) – A report to the legislative council and the Senate and House committees on insurance and commerce of the Arkansas General Assembly (as required by Act 1452 of 2003)
  22. ^ "As a Hiring Filter, Credit Checks Draw Questions", The New York Times, April 9, 2010
  23. ^ a b "Credit Scores: Not-So-Magic Numbers" Business Week, Feb. 7, 2008.
  24. ^ Credit scores didn't fail in screening applicants for subprime loans(April 7, 2008)By PAMELA YIP / The Dallas Morning News
  25. ^ http://www.ncsl.org/issues-research/banking/use-of-credit-information-in-insurance-2011-legisl.aspx
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