Calculating a Credit Score or Rating
Credit scoring methods vary from one scoring model to another, but the most widely used scoring system in U.S., Canada and other areas around the world is FICO. The factors are similar and may include:
- Payment history (35% of the FICO score) – Poor or erratic payment history can lower your credit rating or score. The following are considered negative events: charge offs, collections, late payments, repossessions, foreclosures, settlements, bankruptcies, liens, and judgements. Within this category FICO considers the severity of the negative item, the age of the negative items and the prevalence of negative items. Newer is worse than older. More severe is worse than less severe. And, many is worse than few.
- Debt (30% of the FICO score) – FICO considers three different types of debt based on the amount and type of debt carried by a consumer.
-
- Revolving debt – This is credit card debt, retail card debt and some petroleum cards. And while home equity lines of credit have revolving terms the bulk of debt considered is true unsecured revolving debt incurred on plastic. The most important measurement from this category is called “Revolving Utilization”, which is the relationship between the consumer’s total combined credit card balances and the available credit card limits, also called “open to buy.” This is expressed as a percentage and is calculated by dividing the aggregate credit card balances by the aggregate credit limits and multiplying the result by 100, thus yielding the utilization percentage. The higher that percentage the lower your score will likely be. This is why closing credit cards is generally not a good idea for someone trying to improve their credit scores. Closing one or more credit card accounts will reduce your total available credit limits and likely increase the utilization percentage unless the cardholder reduces their balances at the same pace.
- Installment debt – This is debt where there is a fixed payment for a fixed period of time. An auto loan is a good example as you’re generally making the same payment for 36, 48, or 60 months. While installment debt is considered in risk scoring systems it is a distant second in its importance behind the revolving credit card debt. Installment debt is generally secured by an asset like a car, home, or boat. As such, consumers will use extraordinary efforts to make their payments so their asset isn’t repossessed by the lender for non-payment.
- Open debt – This is the least common type of debt. This is debt that must be paid in full each month. An example is any one of the variety of charge cards that are “pay in full” products. The American Express Green card is a common example. Open debt is treated like revolving credit card debt in older version of the FICO scoring system but is excluded from the revolving utilization calculation in newer versions.
- Credit File Age (15%of the FICO score) – The older your credit report the more stable it is considered to be. As such, your score should benefit from an old credit report. This “age” is determined by two factors; the overall age of your credit file and the average age of the individual accounts on your credit file.
- The overall age of your credit file is determined by the oldest account’s “date opened”, which sets the age of the credit file.
- The average age is set by averaging the age of every account on the credit report, whether open or closed.
- Account Diversity (10% contribution on the FICO scale) – Your credit score will benefit by having a diverse set of account types on your credit file. Having experience across multiple account types (installment, revolving, auto, mortgage, cards, etc.) is generally a good thing for your scores because you’re proving the ability to manage different account types.
- Credit Inquiries (10% of the FICO score) – Every time a company requests some information from your credit file an inquiry is noted. Not all credit inquiries are negative however. “Soft” Inquiries have no effect on the creditworthiness of a consumer they remain on your credit reports for 6 months and are never visible to lenders or credit scoring models.
Soft Credit Inquiries are:
- Prescreening inquiries where a credit bureau may sell a person’s contact information to an institution that issues credit cards, loans and insurance based on certain criteria that the lender has established.
- A Periodic Check by a creditor. This is referred to as Account Management, Account Maintenance or Account Review.
- A credit report with no adverse action.
- Checking Your Own Credit Report – This is referred to as a “consumer disclosure” inquiry.
- Employment screening inquiries
- Insurance related inquiries
- Utility related inquiries
Hard Credit Inquiries can have an effect on your creditworthiness and are:
- Inquiries that are made by lenders when consumers are seeking credit or a loan.
- Too many inquiries over a short period of time on a person’s report may signal that the person is in financial difficulty and seeking a lot of credit. Lenders may consider that person a poor credit risk.
This article uses material from the Wikipedia article bad credit, which is released under the Creative Commons Attribution-Share-Alike License 3.0.
Image courtesy of Stock Images / FreeDigitalPhotos.net
