In the U.S., the three credit bureaus compute credit scores based on the credit scoring model developed by the Fair Isaac Corporation. FICO is the acronym for Fair Isaac Corporation. Hence, the scores developed by the credit bureaus, viz. Experian, TransUnion, and Equifax are also known as the FICO scores. In addition to developing the first credit scoring system, in the year 1958, Fair Isaac Corporation is also the largest provider of consumer credit scoring models. At any point in time, a person has a credit score computed by each of the three bureaus. These scores may vary depending upon the model used.
Credit Score Components
Credit scoring is a statistical technique that is used to assess the prudence of extending credit to a borrower. It determines the extent to which the lender may stretch his/her purse strings. According to the Equal Credit Opportunity Act, a credit scoring model cannot incorporate the following factors: race, sex, marital status, nationality, and religion. If the model gives weight to age, it must ensure that older applicants are not discriminated on the basis of age. Credit bureaus are believed to assign the following weights to factors while calculating credit scores: 35% to previous credit performance, 30% to the level of current indebtedness, 15% to the use of time credit, 10% to the types of credit available, and 10% to any new credit that is availed. Hence, a credit score is calculated on the basis of factors that can be expressed in numerical terms in order to eliminate the question of bias.
There are five components that decide the credit score. These are categories laid down by FICO to rank an individual's creditworthiness. To maintain a good FICO score, managing money, and respecting time are precursors second to none.
Payment History: Pay attention to bill payment cycle. Does it reflect a train of delays with regard to payment? A contrite payment history may lead your FICO score to drop. In other words, a defaulter, who is lax about his growing debt history, will have a FICO report that puts forth the facts in the form of scores. If you are consistent and adhering to timely payments, your FICO score, too, would be consistently good. Your payment history constitutes a share of 35% of the credit score rating in toto.
Using Credit: This component constitutes 30% of the rating. This component measures the current credit card balance considering the background of the total credit limit; credit cards being the primary source of revolving credit. Repaying the debt and keeping a tab on the ratio of current credit utilized and the total credit limit may improve the credit score. Besides, there exists a misconception that closing a credit card account, may aid in improving the overall credit score. Well, the fact stays pat that if you close an old account, your credit utilization ratio is hampered. This happens because you are flippantly barricading the credit that is currently available, which increases your credit utilization ratio. This is a dicey situation. Being prompt with paying off the debt would do a good turn to your FICO score. This does not mean credit cards are an inadvertent bane. They, sure, are a boon, provided you use them responsibly.
Period of Credit History: Opening new accounts at a stretch may hamper your credit score. Besides, a good and a longer credit history will have a positive impact on your credit score as it has adequate information about one's credit behavior. This component constitutes 15% of the total credit score rating.
New Accounts: This section constituting 10% of the credit score rating is based on the frequency at, and speed with which new accounts are being opened. A rapid range of opening multiple accounts may suggest to the FICO board that one is in desperate need of financial aid and thus, requires multiple accounts to facilitate monetary transactions. At this rate, FICO is bound to rank you low on their scale.
Different Types of Credits Used: An individual scores better on the FICO scale, if their credit record reflects a mixed credit history; i.e., if you are paying off different types of debt, you do possess decent knowledge on managing all types of credit. A mix, thus, of revolving credit, mortgage loan, or installment loans stand a better chance to acquire loans in the future, as well. This is because they debilitate the risk accruing on the part of the lender. A 10% of the total credit rating is based on this variable.
The Interpretation
All scoring models have a range. Generally, if one scores poorly, one can expect to be in the lower end of the range. A person's credit score or the FICO score is a number between 300 and 850. Range is a measure of dispersion and is defined as the difference between the maximum and the minimum value. Since a credit score ranges between 300 and 850, FICO scores have a range of 550.
Generally, a person whose credit score lies in the lower end of the range, will find it difficult to procure loans at a reasonable rate of interest. A good credit score, especially is useful, when it comes to getting a mortgage on the house, or for procuring auto loans. A score of 350 is indicative of high credit risk, while a score close to 850 presents the likelihood of the credit that was extended, being repaid as agreed.
Prime: A credit score that ranges between 680 and 850 is considered a good score. A borrower with a credit score in the aforementioned range is known as a prime borrower. The borrower will have no difficulty in seeking loans and can hope to avail a loan/mortgage at a low rate of interest, provided the borrower's debt to income ratio is favorable. This ratio indicates the ability of the borrower to repay the borrowed sum.
Sub-Prime: Generally, a score in the range of 620-679 will make one a sub-prime borrower. A sub prime borrower is charged a higher rate of interest on loans as compared to a prime borrower. Before the housing market crashed, it was possible for sub-prime borrowers to get a mortgage loan at a low variable rate of interest. However, in the present situation, a sub-prime borrower will find it impossible to avail a loan with a low Annual Percentage Rate (APR).
Shafted: A score between 620 and 560 may force a person to put up additional collateral or security to avail a loan at a reasonable rate of interest. A credit score below 560 may force a person to approach a hard money lender on account of being jilted by the conventional lenders.
Before the housing market crashed, a sub-prime borrower could have easily availed a variable rate mortgage loan at a low initial rate of interest. This floating rate of interest was based on the prime rate. Once the prime rate escalated, the borrower's interest rate gathered an upward momentum leaving the sub-prime borrower in the unenviable position of being unable to repay the loan. Refinancing, also, was ruled out, once the home prices stated falling. Lending to the sub-prime borrower not only affected the lender, but also the borrower, whose credit score was further damaged on account of foreclosure.
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