Credit Scores and Credit Reports, by Evan Hendricks

Chapter 1

Basics of The Credit Score

If winning isn't everything, why do they keep score?           

- Vince Lombardi  

All right, everyone, line up alphabetically, according to your height.           

- Casey Stengel  

A Brief History

The Fair Isaac Corporation first developed models for calculating credit scores in the late 1950s. Credit scores started gaining widespread use in the late 1980s and came to consumers' attention in the late 1990s when mortgage lenders began considering credit scores in their loan underwriting. They helped usher in today's era of "automated underwriting" and "credit decisioning," in which large organizations can decide, via computer, whether or not to grant you credit or insurance-no human involvement necessary.

Despite their importance and growing popularity among businesses, to consumers, credit scores were shroud-ed in mystery. It was not clear how they were calculated or who was using them. In fact, the Federal Trade Commission (FTC) put out an opinion stating that federal law did not require the credit bureaus to reveal credit scores to consumers who requested their credit reports. This was in part, because the 1996 revisions to the Fair Credit Reporting Act (FCRA) specified disclosure was not required of "any information concerning credit scores or any other risk scores or predictors relating to the consumer."¹⁴

Public criticism of this policy mounted as the vital role of credit scores in credit and insurance decision-making became evident. The changing environment was best illustrated by a situation that arose in February 2000 at E-Loan, an Internet lender that could quickly approve mortgage and auto loans, in part because credit scores facilitated automated decision-making. To better advise consumers where they stood, E-Loan decided to tell prospective loan applicants their FICO scores — a radical move at the time. Within a month, thousands of people took advantage of the service.¹⁵

But the move sparked an uproar in the credit industry, as two of the three national credit reporting agencies (CRAs) moved to cut off E-Loan's use of credit scores. E-Loan ultimately prevailed when California passed a state law, sponsored by State Sen. Liz Figueroa, requiring lenders to provide California mortgage and home equity applicants with the score used in their loan decision. The law also required Equifax, Experian and Trans Union to disclose credit scores to consumers who requested them.

"The passage of this law is a giant step forward for California consumers, but there's still more that needs to be done," said Chris Larsen, E-Loan's Chairman and CEO. "This is information that should be readily and freely available to consumers nationwide. There should be very little difference between getting information about a stock or mutual fund and finding out your credit score. Just like consumers can research an investment before they commit their money to it, consumers should have free access to information about their credit score before they apply for a loan."<sup>16

14</sup> 15 U.S.C. Sect. 1681g(a)(1)
¹⁵ E-Loan Opens Over 10,000 Personalized Loan Management Accounts In First Month," E-Loan Press Release, March 23, 2000
¹⁶ E-LOAN, Inc., A Full Credit Score Disclosure Pioneer, Calls For National Legislation," E-Loan Press Release, June 27, 2001

Larsen's plea was fulfilled — well, almost. Although scores won't exactly be "freely available," a new federal law requires credit bureaus, for a "fair and reasonable" fee, to disclose to consumers their credit scores and how those scores are determined. The FTC will set rules instructing the credit bureaus how to do this. The federal law also requires mortgage lenders to disclose scores. However, the new law appears not to require CRAs to provide consumers with the scores that lenders actually use. Instead, they can disclose "educational scores," meaning FICO "knock-offs" that approximate scores used by lenders, but which can differ significantly. (More on this later.)

Critics said even the California law fell short of its goals, as CRAs initially did not publicize its requirements, made it difficult for consumers to learn about their scores, and charged rather high fees.

What Is A Credit Score?

A credit score is a number that reflects your credit worthiness at a given point in time. For most models, the higher the score, the better the risk.¹⁷ People with higher scores often can obtain mortgages, credit cards, loans, and insurance at more favorable rates. Conversely, the lower the score, the less favorable the terms will be in any offer that is made. The credit score is based on data in your credit report, which is why the bulk of this book is devoted to credit reports, and the system that creates them.

Each Bureau Has Its Own

Although similar in many aspects, each of the three major credit bureaus has a different name for their FICO credit score. There's Equifax's "Beacon," Trans Union's "FICO Classic," and the "Experian/FICO Risk Model."<sup>18

17</sup> The bankruptcy score runs from 0-1000 with higher being worse.
¹⁸ Up until 2004, the TU FICO score was called "Empirica"

The general scoring range is 300-850. Fair Isaac divides the scoring range into five risk categories:

• 780-850 - Low Risk
• 740-780 - Medium-Low Risk
• 690-740 - Medium Risk
• 620-690 - Medium High Risk
• 620 and Below - High Risk or "sub-prime."

All of these generalities come with a note of caution. First, a credit score can change quickly for several reasons, including late payments or significant increases in credit balances. Second, each credit bureau might not have identical data about you, in large part because many creditors only report to one or two bureaus rather than all three, resulting in different credit scores among the three. Third, some creditors and insurers use their own formulas, or "templates," to calculate credit scores, either in conjunction with a general-purpose model like FICO, or by themselves. For example, a mortgage lender will want the formula to zero in on one set of a consumer's payment characteristics, while an insurer or sub-prime credit card issuer will emphasize a different set. Fourth, the credit score itself might play a different role in different contexts. For some types of credit, the score could be the predominant factor in setting interest rates and credit limits. But in the insurance context, the "credit-based insurance score," typically is one of many factors determining whether a policy is underwritten or at what premium. Some lenders and insurers, along with using a score, also scan the credit report for major "derogatory" terms like bankruptcy, judgment, foreclosure, or collection.

How Is the Credit Score Calculated?

Like the Coca-Cola formula, the precise formulas that are used for calculating various kinds of credit scores are well-guarded trade secrets. Nonetheless, Fair Isaac has released enough information to give a very general idea of how scores are calculated.

Remember, the score is calculated by analyzing the "whole" of credit information in the report and the various factors that make up that whole. No singular piece of information or factor by itself determines your credit score.

Factor 1: Payment History (35%)

Your payment history is the first and most important factor because, obviously, "The first thing any lender would want to know is whether you have paid past credit accounts on time." On the other hand, Fair Isaac says that this usually only amounts for 35% of the score on average. Late payments are not an automatic "score-killer," as an overall good credit picture can outweigh one or two late credit card payments. At the same time, having no late payments in your credit report does not mean you will get a "perfect score." Some 60%-65% of credit reports show no late payments at all, the company says.

The factors that are considered in calculating your payment history include:

• Track record with various lenders. Do you pay all your credit obligations on time, including mortgages, credit cards, store charge cards, home equity loans, auto loans, finance companies, and personal loans? The greater the number of accounts without late payments, the better the score.


• Length Of Positive Credit History. The longer the better.


• Length of Time that has Passed Since the Most Recent Negative Item. It is vital to realize that the more recent a public record or delinquency, the more that delinquency will lower your credit score.
• Severe Unpaid Debts - Public Records. The most negative credit failures are reflected in public records, as the account(s) at issue resulted in court action. Bankruptcy, foreclosure, court judgments, wage attachments, tax liens, and collection lawsuits, particularly if recent, can cause a credit score to plummet.


• Severity & Quantity of Delinquencies. While one 30-day late payment from four years ago would have a minimal impact on an otherwise positive credit history, the presence of three separate 90-day lates in the past year would have a major detrimental effect. Also severe are unpaid accounts that are sent to collection agencies or are "charged off."

Factor 2: Amount Owed-Extent of Indebtedness (30%)

How much debt is too much? The FICO system wants you to have debts, but not too many. More important, it sets standards as to whether you manage your debt responsibly. As Fair Isaac puts it: "Owing a great deal of money on many accounts can indicate that a person is overextended, and is more likely to make some payments late or not at all. Part of the science of scoring is determining how much is too much for a given credit profile."

• Quantity of Credit Accounts. Too many credit cards can lower a score because FICO sees it as increasing risk. On the other hand, if you have no credit accounts, you will not be able to build a credit history. Fair Isaac warns against thinking there is an "optimal number" of credit cards.


• Ratio of Credit Balance To Credit Limit. Are you using a fraction of the credit that is available to you, or are you "maxed out" on your credit cards every month? The ratio of your credit balance to your credit limit is a key factor in scoring your indebtedness. Some experts say that using only one-third of your available credit is optimal.
• The Amount Owed on All Accounts. How much are you dipping into debt? Remember, even if you pay off your credit cards in full every month, your credit report may show a balance on those cards. The total balance on your account at the time the credit card company reported it to the bureau often is the amount that will show in your credit report.


• How Much Is Owed On Each Type of Account? In addition, for the overall debt total, FICO scores the amount you owe on specific types of accounts, such as credit cards and installment loans. Fair Isaac says: "In some cases, having a very small balance without missing a payment shows that you have managed credit responsibly, and may be slightly better than carrying no balance at all. On the other hand, closing unused credit accounts that show zero balances and that are in good standing will not raise your score."
• How Much of Mortgage or Other Installment Loans Are Paid Off? How much was the original loan amount, and how much have you paid off so far? Fair Isaac says: "Paying down installment loans is a good sign that you are able and willing to manage debt responsibly."
• How long have specific credit accounts been established?


• How long has it been since you used certain accounts?

Factor 3: Length of Credit History-The Longer, The Better (15%)

Fair Isaac breaks this category down accordingly:

• Overall Length of Credit History (In General). How many accounts, how long?

Factor 4: How Much New Credit? (10%)

This category basically is to flag people who suddenly are seeking new lines of credit, possibly indicating they are about to overextend themselves, or possibly already are getting in over their heads. As Fair Isaac says: "Research shows that opening several credit accounts in a short period of time does represent greater risk-especially for people who do not have a long established credit history."

• How many new accounts, particularly credit card accounts?


• How long has it been since you opened a new account?


• How many recent requests for credit have you made, as indicated by inquiries to the credit bureaus? Inquiries remain on your credit report for two years, although FICO scores only consider inquiries from the last 12 months. Fair Isaac emphasizes it only considers inquiries for which you were applying for different kinds of credit, as opposed to the multiple inquiries that might result if you were shopping for the best mortgage rate or car loans.


• Length of time since credit report inquiries were made by lenders.


• Whether you have a good recent credit history, following past payment problems. This is a biggie for people hoping to re-establish their credit by making payments on time after a period of late payment behavior to help raise a score over time.

Factor 5: Type Of Credit (10%)

Fair Isaac refers to this as measuring whether you have a "healthy mix" of installment (mortgages and loans) and revolving credit (credit cards). It's not entirely clear what's "healthy" and what isn't. Loans from banks are considered positive, while finance company loans are not.

Inquiries — Fair Isaac's Clarification

At one point in the 1990s, many people believed that inquiries to their credit report caused their credit scores to drop. Some felt they were being "responsible consumers" by shopping for the best mortgage rate. But the multiple appli-cations prompted a flurry of inquiries, making it appear that the consumer was trying to buy the whole neighborhood, not just one house.

Some consumers who saw their credit reports worried that inquiries resulting from pre-approved offers were lowering their scores. In fact, these inquiries only appear on the report disclosed to the consumer, and are not printed on the report seen by creditors. They are not used in scoring.

Accordingly, Fair Isaac emphasizes that it only counts inquiries that are caused by consumers applying for credit. Here's what else Fair Isaac says:

• Inquiries don't affect scores that much. For most people, one additional credit inquiry will take less than five points off their FICO score. However, inquiries can have a greater impact if you have few accounts or a short credit history. (In other words, the system is designed to flag inexperience people who could be in danger of overdosing on the joys of credit.) Large numbers of inquiries also mean greater risk. People with six inquiries or more on their credit reports are eight times more likely to declare bankruptcy than people with no inquiries on their reports, Fair Isaac said.
• Many kinds of inquiries aren't counted at all. The score does not count it when you order your own credit report or score. Also, it does not count inquiries related to "pre-approved" credit offers, or routine account reviews by your current creditors. Employment-related inquiries are not counted either.


• The score doesn't penalize "rate shopping." Looking for a mortgage or an auto loan may cause multiple lenders to request your credit report, even though you're only looking for one loan. To compensate for this, the score counts multiple auto or mortgage inquiries in any 45-day period as just one inquiry.¹⁹ In addition, the score ignores all inquiries made in the 30 days prior to scoring. If you find a loan within 30 days, the inquiries won't affect your score while you're rate shopping.

What Fair Isaac Says It Doesn't Consider

Fair Isaac says its scoring model complies with the Equal Credit Opportunity Act prohibition against using racial or ethnic data in credit decisioning. It also claims: "Independent research has shown that credit scoring is not unfair to minorities or people with little credit history. Scoring has proven to be an accurate and consistent measure of repayment for all people who have some credit history. In other words, at a given score, non-minority and minority applicants are equally likely to pay as agreed."

¹⁹ This protection can break down if auto or mortgage inquiries are not properly coded, recorded or communicated by credit grantors or CRAs.

In a broader context, however, credit scoring can dis-advantage disadvantaged people who are not familiar with the system. For instance, poor and low-income people are usually not mobile and tend to utilize stores and credit grantors within their communities. As these tend to be small, privately owned stores that do not report to credit bureaus or finance companies rather than large banks, these consumers have credit files that suffer from the limited menu of credit options available to them. Many poor and low-income communities have higher concentrations of minorities.

Specifically, Fair Isaac said it does not consider:

• Race, color, religion, national origin, sex, or marital status. Receipt of public assistance, exercise of any consumer right under the Consumer Credit Protection Act.


• Age. (Clearly, underwriting scoring models used by insurers consider age, but these are not Fair Isaac models.)


• Salary, occupation, title, employer, date employed, or employment history. Lenders may consider this information, however.


• Place of residence


• Any interest rate being charged on a credit card or other account


• Any items reported as child/family support obligations or rental agreements


• Certain types of inquiries (i.e., certain requests for your credit report or score)


• Any information not found in your credit report


• Any information that is not proven to be predictive of future credit performance

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© 2005 Evan Hendricks and Privacy Times, Inc. All rights reserved.