Your credit score explained

Understanding the reasoning and methodology behind how your credit score is calculated is very empowering. It is the first step in taking control of your credit score through your spending and borrowing habits. You should also check tips on how to improve your credit score to further enhance your understand. First let’s discuss what exactly the credit score is. It is a numeric number calculated by a credit union such as Equifax or Transunion that aims to predict how an individual will likely pay back their debts based upon their previous payment record. The credit score is typically a number between 300 and 900 and is derived from analyzing the information presented in your credit report. A higher score indicates a better statistical probability that the potential borrower will honor his or her obligations. The FICO score is the score that was developed by the Fair Isaac Corporation and is the most widely used scoring model in the industry. This model generates a number between 300 and 850. There are other credit score models apart from FICO that are used by credit agencies, explaining to a certain extent why your score may vary from bureau to bureau. Also each of the different credit bureaus calculate the score from totally independent data bases. So in addition to a different scoring model, the variation in the actual database will also result in a different credit score from each bureau. You can usually purchase your credit report along with an analysis from the credit bureaus that will go a long way in having your personal credit score explained.

Credit score versus credit report

It is also important here to highlight the distinction between a report and a score, the former is used to calculate the latter. Often people use these two terms interchangeably but in fact they are different. In the US and Canada, an individual is allowed by law to receive a copy of their consumer credit report, however, the credit score may or may not be included when this report is received. It is important to check with the bureau as to what exactly will be sent when a copy of the report is requested. In addition, all the credit bureaus offer a paid service for instantly obtaining an individual’s report online. There are generally different types or packages of information that can be purchased in this way and the pricier packages will offer a credit score along with the report and some analysis of the credit history.

Scores are not the only factor used in lending decisions

Another common misconception about an individual credit score is that there is a magic score above which a person will automatically be approved for obtaining funds. It is important to understand that the credit score is an indicator that is used by the lenders as a guide (it can also be thought of as a preliminary filter of application) in making a lending decision. In addition to this score, the lending institution would likely take many more variables into consideration such as employment income and total overall relationship with the potential borrower. Nonetheless, the weight of the credit score is very important and should not be under estimated.

Credit Score formulas

As mentioned above, the FICO score is one of the models (formulas) used as a credit score, and there are many more. The actual formula is kept confidential but the general variables used are similar from model to model. A good guide line for which factors are considered is as follows. The percentage indicates the amount by which the credit score is approximately impacted by these variables:

35% - payment history, ie how many times have payments on revolving accounts been late in the past and by how many months

30% - debt load, specifically what is the total outstanding balance on all revolving accounts with respect to the total amount of available credit

15% - age of the accounts being reported, ie. A car loan account that has been active for 4 years and has been paid for four years has a different impact compared with a car loan account opened two months ago with similar payment patterns

10% - the different types of credit on record, ie. A credit card debt is weighed differently than say a home equity loan

10% - the number of hard inquiries on the credit report, hard inquiries are generated when someone applies for new credit

Over and above these factors, many other things are also considered. For example, a collection agency reference on the credit report or court orders from public records all reduce the credit score. Since the actual formulae are trade secrets, there is always an ‘unknown’ as to exactly how a particular credit event will impact the credit score. For example, if someone suddenly maxed out all available credit and consequently the debt load increased, the overall impact on the credit score may be much higher that the 30% attributed to this factor in the above guide.

How long does information impact the credit score

The length of time that records on a credit report are actually used in the calculation of the score depends on which state or province you live in, the credit bureau generating the score and the type of information it is. For example, a first bankruptcy filing will affect the credit score for 6 years in some provinces in Canada and seven years in other provinces. Similarly, reporting times vary in different states. In general terms, an event will be used in calculating the credit score from 2 to 7 years after it occurs. The exact times are available by contact the local credit bureau in your area.

What is considered to be a good credit score

This is a very common question yet it can only be answered in general terms since a credit score is not interpreted with a cut-off type decision making process. Every lender has a different tolerance for risk and will consider the credit score (along with the other information they deem necessary) in making their decisions. In general, a class A lender will only consider higher scores while a lender specializing in the sub-prime market will consider a lower score (higher risk) against expectations of higher returns (higher interest rates). In fact, even though it is rare, a situation can arise whereby an individual with a specific credit score finds it difficult to secure funds because their score is too low for a class A lender but it is too high for a sub-prime lender active in the region. To this end, reputable mortgage or loan brokers can roughly determine which lenders a deal should be presented to in light of their knowledge of the borrower’s credit score and history.

In terms of numbers and using the FICO model, the mean credit score is approximately 720; meaning half of the people fall below and half above this score. Furthermore, the lower half of the scores are further away from the mean than the upper half. It is important to view the credit score from the perspective of how it compares to other peoples in the market. That is how a lender views it. In other words, a particular lender will usually have sales targets they have to meet and they will then determine how much risk they are willing to take; as such they will then determine for example that they will lend to the top 10% of the population or top 10% of the credit scores in their market. Credit bureaus will usually also provide some analysis and comparison information when you purchase your report from them. This information can be used to intelligently evaluate how your score compares with the general population.

How can a low credit score be improved

If you feel your credit score is low, your first action should be to order credit reports from all three major bureaus and check the reports carefully for any mistakes. Such mistakes occur more often than not and you have the legal right to correct genuine mistakes. Secondly, you should also check that your credit score is based upon current information. For example there may be a small department store credit card that you have paid off but is still showing a balance on your report. This balance would then raise the debt ratio used in calculating the credit score. Once such mistakes and outdated data have been corrected, the only way to raise the score is through sound management of your debt. It is very important not to fall for services that claim to repair your credit or raise your score in a short period of time. Credit scores are designed to indicate the likelihood for a person to honor their debt obligations, and so the score will not automatically jump up immediately if you pay off some outstanding or overdue account. The fact that the overdue account went into arrears in the first place is at the center of the credit reporting industry and so this will certainly impact the score even after the debt is settled. Over the medium to long run, if you consistently keep meeting your obligations and pay bills on time, the credit score will adjust accordingly. You can also consider lowering your total debt load by selling a car for example that is too expensive. For example if you have a $25000 balance still outstanding on your vehicle and you are lucky enough to be able to sell the vehicle at a price that can pay off that balance, then the wise move may be to sell the car and buy a $10000 car. If the $10000 car is purchased for $1000 down, then you have effectively reduced the debt load from $25000 to $9000. This will likely have a positive impact on your score. Another important consideration is allocating the monthly income properly. For example if you want to positively impact your credit score and you have $500 left over each month after all the bills are paid, you should use the extra $500 to further reduce any outstanding credit card balance opposed to using it to reduce the balance on a installment loan. A lower balance on the credit card will likely have more impact than the latter in raising the your score. Be advised that these are suggestions and should not be relied upon as definite ways to improve credit. When all is said and done, a well managed, disciplined and punctual repayment of all your debts is the only way to improve your credit score.

Credit Score at FCAC
Financial Consumer Agency of Canada, elaboration on your credit score

FICO Credit Score Site
Link to the FICO website. The FICO credit score is the leading model in the industry.

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