Monday, October 9, 2017

What is a Credit Score?

Posted by: Odysseas Papadimitriou

 

Your credit score is essentially your credit history expressed as an easy-to-reference number. You can think of it as a grade for how responsibly you’ve managed loans, lines of credit, and other financial obligations over the years. Credit scores are extremely important because they affect your mortgage rates, the credit card offers that you receive, the premiums that you pay on your car insurance, your ability to buy a car, and even where you are able to live and work.

Interestingly, the breadth of a credit score’s impact is one thing that many consumers do not really comprehend. “I don't think consumers are aware that credit scores are used by potential employers, potential landlords and others to make important decisions (and judgments) about that individual nor do they understand the negative impact of a poor credit history,” says Maureen Karig, senior research associate with the Center for Business and Industrial Studies at the University of Missouri – St. Louis. “Consumers need to take their credit histories seriously and understand that credit reports can show every mistake one has made and that a poor score is costly.”

It’s therefore worth checking out the following sections below:

  1. Credit Scores In Depth
  2. How Credit Scores Change Over Time
  3. Checking Your Credit Score
  4. Ask the Experts: Credit Score 101
Credit Scores In Depth

Credit scores are all based on the information in your major credit reports, and understanding that connection is the first step to understanding your credit score. This also represents a knowledge gap for a lot of people.

"Most consumers don’t have a clear idea how credit scores work and what on a credit report determines a credit score,” says Larry Garvin, a professor at The Ohio State University College of Law who specializes in small business and entrepreneurial finance. “I suspect most know that the two are related, but I also suspect most don’t know how. Probably most of this deficiency is due to weak financial literacy, with some due to weak literacy and some due to the sheer amount of information and disinformation that’s out on the Web or elsewhere."

So, let’s clear a few things up.

Contrary to popular belief, you don’t have just a single credit score that everyone references. There are actually more than 1,000 different types of credit scores available, and they use different calculation methods and information sources and are based on different ranges (i.e. they’re out of different maximum numbers).

The most widely used credit scores are those from VantageScore and the Fair Isaac Corporation. Although an individual can have more than 50 different credit scores just from these two companies, each company’s scores all tend to share the same general composition. Below, you can find the breakdown of the ingredients in the scores that you’re most likely to both come across and be evaluated with. Keep in mind that while other credit scores may be calculated differently, it’s fair to expect that if you have good marks in each of the following categories, your credit score will be good regardless of the particular model used.  

Vantage Score FICO Score
VantageScore FICO Score

 

  1. Payment History
  2. Amounts Owed (Utilization, Balances & Available Credit)
  3. Length/Depth of Credit History
  4. Types of Credit Used
  5. New/Recent Credit
Payment History

Payment history is the most important component of any credit score, accounting for up to 40% of your overall rating. It is based on the records the major credit bureaus – Experian, Equifax, and TransUnion – keep, which indicate the following:

  • The number of loan and credit accounts that you have always paid on time.
  • The number of accounts for which you are currently at least 30 days behind on payment.
  • Whether or not you have gone bankrupt, been ordered by a court to pay amounts owed, had past due accounts sent to collections, or have fallen at least 30 days behind on a loan or line of credit. The recency of these items will also factor in.
  • How many days past due you are on delinquent accounts.
  • The dollar amount past due you are on delinquent accounts and/or accounts sent to collections.

Given that a credit score is a reflection of your financial responsibility, it makes sense that you will be knocked for failing to make payments as agreed on certain types of accounts.

Amounts Owed

The money that you owe to creditors and lenders accounts for at least 30% of your score. The decision makers who use credit scores want to get a sense of whether or not your spending habits are sustainable as well as the likelihood that your current debt burden will lead to serious problems with your finances in the future.

The Amounts Owed component of your score is comprised of:

  • The number of accounts that you carry a balance on.
  • How much you owe on existing credit cards and installment loans.

Lower is better with each of these data points, which may be grouped together or separated into individual scoring categories, depending on the type of credit score. VantageScore, for example, has separate categories for balances, available credit and utilization.

Length/Depth of Credit History

This portion of your score merely reflects the length of time that you have been using loans and lines of credit. People with a long track record of responsible money management are viewed favorably by creditors, and years of positive information will make the occasional missed payment less impactful.

This, along with the types of credit you use, comprises the Depth of Credit portion of a VantageScore.

Types of Credit Used

This credit-score component indicates how well-rounded your financial management skills are based on the different types of accounts (e.g. credit cards, installment loans, retail lines of credit, mortgages, etc.) you’ve used and how recently you have used them.

New/Recent Credit

Credit-scoring companies use this “what have you done for me lately” category to emphasize recent financial performance, as it – perhaps more than anything else – indicates future performance. This section includes:

  • The number of loans and lines of credit you have taken out in recent months as well as how that number compares to the total number of accounts in your credit history.
  • How long it has been since you’ve opened your newest accounts.
  • The number of hard inquiries (i.e. how many times you’ve applied for credit) made into your credit history in the last 12 months.
  • How long it has been since your last credit inquiry.

In short, creditors want to determine whether or not you are desperate for additional credit, as that may reflect negatively on your current financial situation.

How Credit Scores Change Over Time

As you might expect given the aforementioned metrics and the fact that credit scores are based on data from your major credit reports, your credit score is a fluid entity. In other words, it stands to change over time as you open new accounts, your spending and payment habits change, etc.

This new information is factored into your credit score each time an inquiry is made (i.e. when a creditor reviews your credit history). It’s interesting to note that people have reported month-to-month credit score fluctuations of around 20 points without anything significant changing in their credit profiles.

Checking Your Credit Score

If you are interested in checking your credit score, there are a number of ways that you can do so. However, you should also note that doing so may not be necessary.

For starters, there are countless different credit scoring models and creditors often modify them with proprietary algorithms, therefore creating their own credit scores which you will not be able to access. Depending on the particular model, ordering your credit score may also cost money. It’s therefore an inefficient (and potentially endless) pursuit to try to get the exact credit score that your lender uses.

Taking advantage of your right to a free copy for each of your major credit reports once a year is far more beneficial. Credit scores are based on the information in these reports, after all, and you can easily get a sense of your standing (as well as identify errors and fraud) by simply reviewing your reports.

Many consumers fail to recognize the value of reviewing their credit reports relative to checking their credit scores because they don’t differentiate the two in their minds. But don’t worry if you’re in that boat. Consumer law expert Cary Flitter, who is a practicing attorney and an adjunct professor of law in the Philadelphia area, says that he “would not expect them to” comprehend the difference. “It’s a bit subtle.”

Ask the Experts: Credit Score 101

People often overcomplicate things when thinking about credit scores. So to help simplify things in your mind, we posed the following questions to a panel of personal finance experts. You can see who they are and what they said below.

  • What do you think is the biggest misconception that people have about credit scores?
  • The Consumer Financial Protection Bureau found a 90% correlation among the results produced by a collection of the most popular credit scores - what is the biggest takeaway for consumers?
  • Do you think most people understand there is not a single “real” credit score?
  • Do you think the average person checks his or her credit score often enough?
< > Steven T. Jones Chair of the Department of Economics, Finance and Quantitative Analysis, and John W. Gay Professor of Banking and Finance in the Brock School of Business at Samford University Steven T. Jones What do you think is the biggest misconception that people have about credit scores? I would imagine that a number of people assume that if they pay off their credit card balances in full each month, their balances will show up as zero on their credit reports. What will generally show up is whatever the new balance is as of the statement date, regardless of how much of the prior month’s balance was paid off. And, if that statement-date balance is too high as a percentage of the credit limit, that will generally hurt the individual's credit score -- again, even if the consumer is completely paying the full amount each month. The Consumer Financial Protection Bureau found a 90% correlation among the results produced by a collection of the most popular credit scores - what is the biggest takeaway for consumers? The gist, including this particular statistic, seems to be that more often than not, the various models produce qualitatively similar results regarding whether a given consumer is a good credit risk, even if the exact credit scores are not identical. However, the statistical information also seems to suggest that there are exceptions to that rule. Do you think most people understand there is not a single “real” credit score? I would be fascinated to see the results of a survey on this question. I think there is a good chance that the answer is “no.” Do you think the average person checks his or her credit score often enough? While it seems likely that the proportion of people who consistently stay on top of their credit scores is better now than it was 20 years ago or even 10 years ago, I can’t imagine that it would be anywhere near 50%. My advice to any given individual would be, “If you are wondering whether you ought to be checking your credit scores -- and, at least as importantly, the specific information in your credit report -- more often, you should be.” Paul Larson Professor in the Department of Economics at Anne Arundel Community College Paul Larson What do you think is the biggest misconception that people have about credit scores? People think that a credit score shows the points you earn for past behaviors, and you get rewarded for what you earn. In reality, it is a measure of risk. People incorrectly believe scores are used to reward past behavior, when they are actually used to predict future behavior. Do you think most people understand there is not a single “real” credit score? Yes. Do you think the average person checks his or her credit score often enough? Yes. It is important to know it early enough (before a major purchase) to influence it. It is appropriate that people who don’t know to check it (and probably have lower scores) don’t give themselves time to improve it. This is part of what allows scoring to provide valuable information. David Ely Associate Dean and Professor of Finance in the Fowler College of Business Administration at San Diego State University David Ely What do you think is the biggest misconception that people have about credit scores? Not using credit will help achieve a good credit score. A credit history is needed for a strong credit score. Do you think most people understand there is not a single “real” credit score? People who periodically check their credit score know that it can fluctuate over time, that it is not easily predictable, and it is not closely linked to behaviors. Therefore, most people understand that there is not a single “real” credit score. Do you think the average person checks his or her credit score often enough? An individual planning to apply for a loan should check his or her credit score prior to submitting the application. This would allow the individual to uncover any error in the information that goes into the calculation of a credit score, and ensure that the loan decision is based on correct information. Individuals with knowledge of their credit score can make a more informed decision about the amount of credit they qualify for, and whether the terms of a deal are fair. Identity theft is a very real risk, so it is important to periodically check one’s credit report to detect unfamiliar accounts and activity in a timely manner. It is less important to monitor credit scores on a frequent basis, since credit scores are based on information in credit reports. Benjamin W. Bean Professor of Accounting at Utah Valley University Benjamin W. Bean What do you think is the biggest misconception that people have about credit scores? That if you inquire, it will hurt your score. The Consumer Financial Protection Bureau found a 90% correlation among the results produced by a collection of the most popular credit scores - what is the biggest takeaway for consumers? People do need to check them, to see if there are errors. Do you think most people understand there is not a single “real” credit score? I believe most think there is one, or at least one that counts the most. I understand that some are more reliable, and that more than one may be analysed. Do you think the average person checks his or her credit score often enough? Probably not -- one, because of the first question above. Two, because it may not be as high as hoped and therefore, uncomfortable to hear about. Kelly Hunter Markson Professor in the Business Administration Department at Wake Technical Community College Kelly Hunter Markson What do you think is the biggest misconception that people have about credit scores? Perhaps it is that people think that if they ignore their credit scores, their problems will go away. People do not like to deal with unpleasant information, especially as it deals with finances. Not being proactive in maintaining a good credit score is a mistake. It will make it difficult to borrow money in the future. The Consumer Financial Protection Bureau found a 90% correlation among the results produced by a collection of the most popular credit scoreswhat is the biggest takeaway for consumers? The 90% correlation suggests that the credit agencies are all looking at much of the same information, and measuring the importance of each factor in a similar way. For example, all the credit agencies look at whether you pay your bills on time. Another factor affecting credit scores is the ratio of your debt to income. Again, all the agencies look at that ratio. Do you think most people understand there is not a single “real” credit score? I think most people are generally confused about credit scores. People often learn through hard knocks. They find out their credit score is not good when they want to borrow money. Do you think the average person checks his or her credit score often enough? Unlikely. But they should know that they can get a free credit report from each agency once a year by going to AnnualCreditReport.com. Brandy Hadley Assistant Professor of Finance at Appalachian State University Brandy Hadley When, if ever, do character references help prospective borrowers? Credit references can be important for borrowers with a limited credit history reported to credit bureaus. This is particularly true for businesses where it is more difficult to obtain a detailed credit history. The most valuable corporate credit references are those with whom the firm has had a continued, substantial relationship and current, revolving net terms. For individuals, there are often many overlooked sources of credit references. A consumer's banking history can provide a relevant credit history and evidence of financial viability. Generally, consumers also have lengthy relationships with their cell phone providers, insurers, landlords and utilities, that can prove beneficial when aiming to contextualize a sparse history. Similarly, character references can be used to provide explanations for credit imperfections. However, it is important to note that consumer credit reports are the most significant determinant of credit and therefore, maintaining the individual's credit report should be a priority. David Leach Banking & Marketing Professor at the University of Maine at Augusta David Leach What do you think is the biggest misconception that people have about credit scores? Consumers’ biggest misconception about credit scores, in light of the recent Equifax data breach, is they have serious concerns that either ordering their free credit reports -- under the Fair Credit Reporting Act amendment -- or freezing their credit reports will lower their credit scores. Of course, both acts have no effect on scores. The Consumer Financial Protection Bureau found a 90% correlation among the results produced by a collection of the most popular credit scores - what is the biggest takeaway for consumers? Most credit score producing companies use relatively the same matrix in computing scores. First and foremost, the most important is how the consumers pay their debts -- early, on-time or late. Length of credit history is also an important factor -- with those first two variables generally making up about 50% of a person’s credit score. Other items are hard credit inquiries, diversity of credit, and the misunderstood “utilization rate,” meaning how high a balance is the consumer carrying on their credit accounts, particually credit cards. As a professor in the Banking program at the University of Maine at Augusta, and the author of several consumer guides on credit, I always advise my students and consumers in general to keep their credit card balances below 1/3 of the credit limit -- and in best practice, pay their credit card balances in full each month. Do you think most people understand there is not a single “real” credit score? People generally say, “My credit score is,” meaning they are only aware of a generic credit score complied for them, whereas in practice, there are multiple sources -- FICO, Big 3 credit reporting agencies, etc. -- that compile consumer credit scores. Do you think the average person checks his or her credit score often enough? Yes, consumers are now much more aware of their credit scores than ever before. Credit card giants like American Express and Discover now offer their cardholders a free look at their credit scores through their websites. Not to many years ago, a fee close to $15.00 was necessary for consumers to view their credit score(s). Carlo Silvesti Assistant Professor of Accounting at Gwynedd Mercy University Carlo Silvesti What do you think is the biggest misconception that people have about credit scores? Consumers believe that, the more credit they have available, the higher their credit score will be. They fail to realize that, if they have to much credit available compared to their income, it will actually lower their credit score. Do you think most people understand there is not a single “real” credit score? Most people do not realize that there are 3 credit rating agencies, and that banks, credit card companies and lending institutions use one of the agencies. Do you think the average person checks his or her credit score often enough? Most people do not check their credit card scores often enough. In fact, most people do not check their credit scores at all, until they make a major purchase, such as a car or mortgage. If the finance rate comes in higher than expected, they want to check their score to see why. When requesting a credit card and again, not receiving the rate they wanted, they will check their credit score and ask why. Everyone should check their score at least annually. The consumer needs to work on their credit score by paying off more than the minimum on their credit card balances, and to make timely payments on their loans and mortgages. If more and more hacks continue on businesses, banks, credit agencies and the IRS, consumers should consider checking their credit scores often, and checking the details on their credit card charges. Don Capener Dean for the Davis College of Business at Jacksonville University Don Capener What do you think is the biggest misconception that people have about credit scores? People with high credit scores don’t ever dip into their credit line. Cardholders can maintain a very high (750+) credit score even if they owe $1-3,000 on their credit cards, as long as they consistently pay more than 20% of the card balance. That high a credit score translates into a low interest rate on your card. The reality is that few cards offer less than 12% interest on revolving balances. They treat most of the higher quality borrowers the same in terms of interest rate, but vary the credit lines dramatically. Do you think most people understand there is not a single “real” credit score? Most people assume incorrectly that all major bureaus use the same scoring system. They use different data scores and often vary between 50-80 points. Do you think the average person checks his or her credit score often enough? Yes. I believe Discover and other issuers are making credit score checks a lot more frequent and easy to do. Valrie Chambers Associate Professor of Accounting at Stetson University Valrie Chambers Do you think most people understand there is not a single “real” credit score? No, but the credit scores should correlate fairly well, so I don’t think that it’s critical that they understand this. Do you think the average person checks his or her credit score often enough? No, but this is getting easier to do, as more credit card companies include this information with their statements. Kevin Krieger Associate Professor in the Department of Accounting and Finance at the University of West Florida Kevin Krieger What do you think is the biggest misconception that people have about credit scores? That they are the customers of the credit bureaus. In reality, potential lenders (car dealers, department stores, even cable companies) are the customers who buy information on consumers from the bureaus. This can make for challenging communication with credit bureaus when something is misleading or mistaken on a credit report. Thus, it's always a good idea to check credit scores regularly and especially in advance of major credit purchases, so that issues can be addressed. The Consumer Financial Protection Bureau found a 90% correlation among the results produced by a collection of the most popular credit scores - what is the biggest takeaway for consumers? Generally, credit bureaus are viewing the same information, and thus their reporting will be close from one to the next. However, it's possible for items to only show up on one credit bureau's database, and this can be a problem if the issue in question is mistaken. I'd suggest a regular rotation of viewing each of your free credit reports once a year by staggering checks of them every four months. Do you think most people understand there is not a single “real” credit score? People tend to know that there are mysterious sounding agencies that keep track of their credit, and do so with a score. But most people don't understand the scoring system, the ramifications of various scores, or how to build better scores. The information is out there (e.g., credit scores are built by a lengthy, consistent pattern of paying bills on time, and some sources even claim to know the exact formula for credit scoring), but it's rather vague and opaque, unless you go looking for it. Do you think the average person checks his or her credit score often enough? No. Unfortunately, like medical issues, people usually only go deep into the details when there's already a problem. It's good to set a reminder for yourself in your calendar, every four months, to check one of your three major credit bureau files. You can do so once a year, for free, at AnnualCreditReport.com (you do not need to use one of those pay services that you see/hear advertised). Iif you rotate each of your three free credit reports once per year, you'll be able to check one of them every four months. Peter Basciano Associate Professor at Augusta University Peter Basciano What do you think is the biggest misconception that people have about credit scores? Oftentimes people fail to see the broader impacts of their credit scores. Although they are likely to have awareness that their credit score affects their availability of credit, they may lack awareness that it also impacts a wide range of other things, like their borrowing costs, employment opportunities, ability to rent property, required security deposits, or ability to gain security clearances. The Consumer Financial Protection Bureau found a 90% correlation among the results produced by a collection of the most popular credit scores - what is the biggest takeaway for consumers? Although there are many different scoring models used to derive a credit score, the underlying factors considered in the models are very similar. In general, regardless of the scoring model used, things like the number of accounts an individual has open, the mix of the accounts, the amount of credit used relative to the amount available, length of credit history, payment history, and the number of recent credit inquiries will impact the credit score. In many ways, this is good news from a consumer’s perspective, as it creates general guidelines for them to establish and manage their credit scores, regardless of the scoring model. For example, paying your credit accounts on time, avoiding applying for too many new accounts and high credit utilization rates on credit cards will most likely positively impact your credit. Do you think most people understand there is not a single “real” credit score? No. When people are asked about their credit score they oftentimes will refer to a single number. Advertisements may help reinforce this misconception as they often refer to a single credit score or urge people to know their score. Occasionally, people may recognize a distinct score for each of the three major reporting agencies. In reality, the major credit reporting agencies use two broad classes of scoring models: Fico and VantageScore. In addition, each of agencies have several different scoring models intended for different applications, such as auto loans, mortgages, or credit cards. On top of all of these scores, banks will frequently have their own internal scoring models. To further complicate the situation, many individuals do not recognize the difference between their credit score and their credit report. According to a 2015 survey by the American Bankers Association, 44% of consumers mistakenly think that their credit score is the same as their credit report. Do you think the average person checks his or her credit score often enough? No. In general, consumers should check their credit reports with each of the major reporting agencies on a regular basis. Each agency is required to provide one free credit report per year, and it is advisable for consumers to take advantage of this option. Further, rather than to check all three at the same point in time, a better strategy is to check one report every four months on a rotating basis. With the widespread occurrence of identity theft and potential for inaccurate reporting, checking a report every four months puts consumers in a better position to notice any potential issues in a timelier manner. Sadly, according to a 2016 report by the National Foundation for Credit Counseling, only 56% of consumers indicated they checked their credit in the last 12 months. Perhaps even more concerning, according to the same report, 36% of people don’t recognize a need to check their credit for any reason.

from Wallet HubWallet Hub


via Finance Xpress
at

No comments:

Post a Comment