Reading Your Credit Report - Part 2

Opinions about the validity and usefulness of credit scores vary from expert to expert. Some supporters of credit scores believe they may solve many of the problems, bias, or discrimination issues found in the lending process. Others maintain that credit scores, due to its basic automation concept, encourages the dehumanizing of the credit granting industry, while some go further and suggest the parameters used to calculate credit scores may prevent underserviced minorities from receiving credit.

While credit scores have been used by the lending industry for a couple of decades, it was not until recently, that credit scores became a hot topic for consumer advocates. Efforts to improve consumers’ understanding of their credit reports brought to light the necessity of consumers also understanding how credit scoring works. For a consumer, the awareness of the impact of credit scores on a borrower’s ability to receive credit and what terms are offered to them is just as important as “shopping around” for interest rates when applying for credit.

While initially considered ‘top secret’, much information has been revealed about the statistical analysis process used to determine a credit score. Yet much confusion remains within the credit industry in understanding credit scores and how best to utilize them. Meanwhile, consumers are often left wondering about what are acceptable credit score levels and how to maintain those levels.

Some of this confusion is due to the variety of credit scoring methods or models used within the industry. Each creditor sets their own standards of what they believe to be an acceptable level of risk for credit approval, but may have a credit score override policy. If a credit score is close but does not meet the accepted creditor standard the lendor may assign a loan officer to manually review the application to make a recommendation in spite of the credit score. (This specific practice raises advocate concerns, as research seems to indicate that a higher percentage of minorities receive a negative response during the manual reviews.)

So, what are the facts?
A credit score attempts to answer the question, “will you pay back credit on time, according to the terms of the agreement?” Credit scores are based on the information found on a borrower’s credit report. Different aspects of the credit report are compared to a ‘sample group’ for characteristics indicating credit worthiness. Your credit score is a statistical ‘snap shot’, if you will, of your level of credit risk. The ultimate purpose is to assist lendors in making effective and consistent decisions about lending money.

The most commonly used model is the FICO score developed by Fair, Isaac and Company. This scoring model is utilized by each of the three major credit reporting agencies (Experian, Equifax, and TransUnion) with some customization. In general, the range of a FICO score is 300 to 850, with lower risk reflected by a higher score. To calculate a FICO score a credit report must list at least one credit account that has been open for six months. If the credit report does not have an account at least six months old or an account that has been updated in the last six months no FICO score will be calculated or reported. The components of the completed analysis are weighted according to specific criteria, however, according to Fair Isaac, there are some variations due to certain factors, such as the previously mentioned short credit history.

Elements that comprise the analysis review include:

  1. Payment history (35%) — late payments may not automatically lower your score, just as the lack of late payments will not automatically raise your score. Other factors under this category include: payment information on the various types of credit listed on your report, details on delinquency, public records and collection items — how old, amounts owed, how far past due, and how many.
  2. Amounts owed (30%) — how much you owe and for what types of accounts, how many accounts have balances, total owed compared to available credit for revolving accounts, and percentage of remaining balance on installment loans in comparison to original loan.
  3. Length of credit history (15%) — how long all and specific accounts have been open and the average age of all your accounts. How long since you used certain accounts is also considered.
  4. New credit (10%) — how many new accounts and how many of the accounts listed are new, how long since accounts were open, how long since lendors made inquiries on the credit report. Good recent credit history following past payment problems is also considered.
  5. Types of credit in use (10%) — Types of credit accounts on credit report and how many of each, for example, revolving, installment, finance companies, banks, or payday loans. (How many is too many of each will vary).

So how do consumers generally score? Fair Isaac supplies the following breakdown by population percentage:

Below 620620-690690-740740-780Above 780

How can you improve your credit score? Sadly, there is no quick answer. Sometimes advice given to improve your credit score can back fire. For example, closing unused credit accounts may appear on the surface to be a great idea. Doing this however, may drive your credit score down due to a now higher percentage of available credit in use, and a shorter length of time for the credit history.

The most effective way to improve your credit score is through diligence. Monitoring your credit report, correcting errors, consistent on-time payments, and judiciously choosing how and when to use credit will all help in maintaining your credit score.

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