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Credit Score


Definition of "Credit Score"

Mark Church
  RE/MAX Direct

A single numerical score, based on information in an individual's credit report, that measures that individual's creditworthiness. Credit scores are based on statistical studies of the relationship between the different items in a credit report and the likelihood of default. The most widely used credit score is called FICO for Fair Isaac Co., which developed it. FICO scores range from 350 to 850, the higher the better. Major Determinants of FICO Scores: Payment History: This is the most important determinant of credit scores. It includes information on the extent to which the subject has made timely payments on mortgage loans, auto loans, credit cards, personal loans, and charge accounts. Delinquencies reduce the score, while timely payments raise it. Payment history also includes information on bankruptcies, foreclosures, legal judgments, liens, and wage garnishments. These will have a major adverse impact, although the impact declines with the passage of time. Amount and Distribution of Current Debts: This is the next most important determinant of credit scores. Unlike payment history, however, it is not always intuitively obvious whether more or less debt, or whether more or fewer creditors, will improve a score. The FICO genie who generates a score does not have information on a subject's income or financial assets. The genie must make judgments about how much debt is too much from information on the debt alone. On debts with debt limits, it focuses on the relationship between the two. It reduces the score when it sees debts that are at or close to the maximum. On installment loans, the genie likes to see the balances going down. A large number of accounts does not disturb the genie, so long as most of them have no balances. Age of Accounts: The FICO genie likes old accounts much better than new ones. Old ones indicate stability in credit relationships, whereas new ones might indicate financial distress if there are many of them. Reason Codes: Every FICO score is returned with up to four ''score factors,' ranked by importance, that indicate why the score was not higher. Examples are 'too many delinquencies,' 'ratio of balances to credit limits is too high,' and 'too many finance company accounts.' The reason codes mean little to someone with a high score. Those with low scores looking to improve, however, will do well to focus their efforts on the major problem areas indicated by the codes. Correcting Errors: Credit reports often contain mistakes that lower the subject's credit score. Perhaps the most common is the inclusion of someone else's accounts. Borrowers who find mistakes must take the initiative to get them fixed, which means writing to the repository reporting the erroneous information and detailing the particulars of the error. Under the Fair Credit Reporting Act (FCRA), a repository has five days from receipt of such a letter to contact the credit grantor that reported the erroneous information and another 35 days to complete its investigation and report back to the borrower. The report must indicate that the error was corrected, or there was no error, or the credit grantor did not respond, in which case the disputed item is dropped from the report. Some Misconceptions About Credit: Many borrowers have misconceptions about how their behavior will affect their FICO score. A Skipped Payment Results in One Delinquency: One misconception is that a skipped payment results in one delinquency record. In fact, however, a skipped payment generates a stream of delinquencies until it is paid. It would be nice if the mortgage contract allowed a skipped payment now and then. Such contracts exist in the UK and some other countries, but they have appeared in the U.S. only very recently and are not yet widely available. Paying off Delinquent Loans Improves the Score: Another misconception is that a credit score will improve if loans that have been delinquent are made current or paid off. This isn't so. Delinquencies lower credit scores because they show a weak commitment toward meeting obligations. This evidence is not wiped away when the loan is repaid. Only the passage of time, along with a better payment record, will wipe it away. The same is true of bankruptcies, tax liens, and judgments. They remain on the record for a period, even after they have been discharged or released. Consolidating Balances Improves the Score: Still another misconception is that the consolidation of credit card balances into a smaller number of cards will increase a credit score. It is true that the FICO genie is much more favorably disposed to four credit cards than to 15. However, the genie is even more concerned with the relationship between the balances on the cards and the maximums. It sees cards that are 'maxed out' as an indication of financial distress. So if the consolidation resulted in a smaller number of cards with balances close to their maximums, the score might drop rather than rise. Authorized Credit Card Users Are Safe: Some borrowers have been surprised to find that their credit score has been reduced by delinquencies on credit cards for which they are not responsible. They are authorized users of cards on which the original credit card holder stopped paying. Even though they are not responsible for making the payment, credit grantors sometimes report authorized users to the credit-reporting agencies as delinquent. Unable to collect from the responsible parties, the original card-holders, the credit grantors hope that maybe the authorized users will pay in order to keep their credit records clean. Credit and Income Can Be Separated in a Loan Application: Some couples want to use the credit score of one spouse (the one with the good score) while qualifying with the income of the other. This doesn't work. Lenders are concerned with the credit score of the borrower whose income they are depending on to service the loan. Use of FICO Scores by Lenders: Most lenders now incorporate FICO scores in their pricing and qualification requirements, but they do it in all sorts of ways. One lender might have 10 different interest rates corresponding to 10 FICO score categories. Another might only use three categories. Still another might set a single FICO score minimum for all loans, but require higher scores for borrowers who want no-down-payment loans, or less than full documentation. Some lenders use FICO scores but supplement them with other information from the credit report that they believe is not adequately weighted in the score. Because the different credit repositories may have different information, lenders typically get two FICO scores and use the lower of the two. Sometimes they get three and use the middle score.



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