Ever wonder how a creditor decides whether to grant you credit? For years, creditors have been using credit scoring systems to determine if you'd be a good risk for credit cards and auto loans. More recently, credit scoring has been used to help creditors evaluate your ability to repay home mortgage loans. Here's how credit scoring works in helping decide who gets credit -- and why.
What is credit scoring?
Credit scoring is a system creditors use to help determine whether to give you credit.
Information about you and your credit experiences, such as your bill-paying history, the number and type of accounts you have, late payments, collection actions, outstanding debt, and the age of your accounts, is collected from your credit application and your credit report. Using a statistical program, creditors compare this information to the credit performance of consumers with similar profiles. A credit scoring system awards points for each factor that helps predict who is most likely to repay a debt. A total number of points -- a credit score -- helps predict how creditworthy you are, that is, how likely it is that you will repay a loan and make the payments when due.
Because your credit report is an important part of many credit scoring systems, it is very important to make sure it's accurate before you submit a credit application. To get copies of your report, contact the three major credit reporting agencies:
Equifax: (800) 685-1111
Experian (formerly TRW): (88 EXPERIAN (397-3742)
Trans Union: (800) 916-8800
These agencies may charge you up to $9.00 for your credit report.
Why is credit scoring used?
Credit scoring is based on real data and statistics, so it usually is more reliable than subjective or judgmental methods. It treats all applicants objectively. Judgmental methods typically rely on criteria that are not systematically tested and can vary when applied by different individuals.
How is a credit scoring model developed?
To develop a model, a creditor selects a random sample of its customers, or a sample of similar customers if their sample is not large enough, and analyzes it statistically to identify characteristics that relate to creditworthiness. Then, each of these factors is assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its own credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company.
Under the Equal Credit Opportunity Act, a credit scoring system may not use certain characteristics like -- race, sex, marital status, national origin, or religion -- as factors. However, creditors are allowed to use age in properly designed scoring systems. But any scoring system that includes age must give equal treatment to elderly applicants.
What can I do to improve my score?
Credit scoring models are complex and often vary among creditors and for different types of credit. If one factor changes, your score may change -- but improvement generally depends on how that factor relates to other factors considered by the model. Only the creditor can explain what might improve your score under the particular model used to evaluate your credit application.
Nevertheless, scoring models generally evaluate the following types of information in your credit report:
Have you paid your bills on time? Payment history typically is a significant factor. It is likely that your score will be affected negatively if you have paid bills late, had an account referred to collections, or declared bankruptcy, if that history is reflected on your credit report.
What is your outstanding debt? Many scoring models evaluate the amount of debt you have compared to your credit limits. If the amount you owe is close to your credit limit, that is likely to have a negative effect on your score.
How long is your credit history? Generally, models consider the length of your credit track record. An insufficient credit history may have an effect on your score, but that can be offset by other factors, such as timely payments and low balances.
Have you applied for new credit recently? Many scoring models consider whether you have applied for credit recently by looking at "inquiries" on your credit report when you apply for credit. If you have applied for too many new accounts recently, that may negatively affect your score. However, not all inquiries are counted. Inquiries by creditors who are monitoring your account or looking at credit reports to make "prescreened" credit offers are not counted.
How many and what types of credit accounts do you have? Although it is generally good to have established credit accounts, too many credit card accounts may have a negative effect on your score. In addition, many models consider the type of credit accounts you have. For example, under some scoring models, loans from finance companies may negatively affect your credit score.
Scoring models may be based on more than just information in your credit report. For example, the model may consider information from your credit application as well: your job or occupation, length of employment, or whether you own a home.
To improve your credit score under most models, concentrate on paying your bills on time, paying down outstanding balances, and not taking on new debt. It's likely to take some time to improve your score significantly.
How reliable is the credit scoring system?
Credit scoring systems enable creditors to evaluate millions of applicants consistently and impartially on many different characteristics. But to be statistically valid, credit scoring systems must be based on a big enough sample. Remember that these systems generally vary from creditor to creditor.
Although you may think such a system is arbitrary or impersonal, it can help make decisions faster, more accurately, and more impartially than individuals when it is properly designed. And many creditors design their systems so that in marginal cases, applicants whose scores are not high enough to pass easily or are low enough to fail absolutely are referred to a credit manager who decides whether the company or lender will extend credit. This may allow for discussion and negotiation between the credit manager and the consumer.
What happens if you are denied credit or don't get the terms you want?
If you are denied credit, the Equal Credit Opportunity Act requires that the creditor give you a notice that tells you the specific reasons your application was rejected or the fact that you have the right to learn the reasons if you ask within 60 days. Indefinite and vague reasons for denial are illegal, so ask the creditor to be specific. Acceptable reasons include: "Your income was low" or "You haven't been employed long enough." Unacceptable reasons include: "You didn't meet our minimum standards" or "You didn't receive enough points on our credit scoring system."
If a creditor says you were denied credit because you are too near your credit limits on your charge cards or you have too many credit card accounts, you may want to reapply after paying down your balances or closing some accounts. Credit scoring systems consider updated information and change over time.
Sometimes you can be denied credit because of information from a credit report. If so, the Fair Credit Reporting Act requires the creditor to give you the name, address and phone number of the credit reporting agency that supplied the information. You should contact that agency to find out what your report said. This information is free if you request it within 60 days of being turned down for credit. The credit reporting agency can tell you what's in your report, but only the creditor can tell you why your application was denied.
If you've been denied credit, or didn't get the rate or credit terms you want, ask the creditor if a credit scoring system was used. If so, ask what characteristics or factors were used in that system, and the best ways to improve your application. If you get credit, ask the creditor whether you are getting the best rate and terms available and, if not, why. If you are not offered the best rate available because of inaccuracies in your credit report, be sure to dispute the inaccurate information in your credit report.
Where can you get more information?
The FTC works for the consumer to prevent fraudulent, deceptive and unfair business practices in the marketplace and to provide information to help consumers spot, stop and avoid them. To file a complaint or to get free information on consumer issues, visit www.ftc.gov or call toll-free, 1-877-FTC-HELP (1-877-382-4357); TTY: 1-866-653-4261. The FTC enters Internet, telemarketing, identity theft and other fraud-related complaints into Consumer Sentinel, a secure, online database available to hundreds of civil and criminal law enforcement agencies in the U.S. and abroad.
This is the absolute fastest way to correct errors on your credit report and raise your credit score. However, it can only be done through a mortgage company or a bank. If you apply for a home loan and find errors on your credit report, request the loan officer to conduct a Rapid Rescore. But don't mistake it for the credit clinic tactic of multiple dispute letters.
The Rapid Rescore strategy requires proper paperwork. You need proof that the item is incorrect. It must come from the creditor directly. For example, a letter stating the account is not your account, a letter stating the account was paid satisfactorily, a release of lien, a satisfaction of judgment, a bankruptcy discharge, a letter for deletion of collection account or any relevant evidence.
This is the same documentation a bank or mortgage company would require for the credit accounts anyways. The difference is, now you can improve your credit score and receive a lower interest rate. The results are not guaranteed and will run you about $50 per account.
2. Deleting Negative Credit
This is the infamous area where you've heard of all the scams. Credit repair clinics charge "an arm and a leg" and promise a clean credit report. Sometimes even a new credit profile! People spending hundreds, or even thousands, of dollars for something they can do themselves.
Removing errors is simple. Deleting negative credit that is accurate requires advanced methods. But that is not the scope of this report. So I'll focus on the deleting the negative errors.
Credit report errors easily disappear by using a simple dispute letter. If you have the paperwork proving the error as mentioned above in Rapid Rescore, send copies of that along with the dispute letter. This will make the credit bureau's job easier and you will get faster results.
If you don't have the documentation to prove the error(s), send the dispute letter anyway. According to federal law, the credit bureau's have a "reasonable time" to validate your claim. They will contact the creditor for verification of your dispute. Then the account will be reported accurately - or deleted. It has been generally accepted the "reasonable time" to complete this task is 30 days.
If you're not the do-it-yourself kind of person. Or don't have the time. You could hire someone who is very economical.
3. PiggyBack Someone's Credit
This is a fast and great little credit score booster. But it requires a very trusting relationship. Simply put, someone else adds you to their credit account. For example, when applying for a credit card, you may have seen the section to add a card holder. If your trusting person adds you, their payment history is now reported on your credit report too. If they have perfect credit, now you have a perfect account.
To make this more effective, use an aged account. Imagine if your trusted person has a 10 year old credit card account with a perfect payment history and a balance of only 50% of the credit limit. Wouldn't you love to have this on your credit report? The easy part is your trusted person just calls the credit card company and requests a form to add a cardholder. Once completed and activated, their entire account history and future is now firmly planted on your account. Imagine if you secured 3-5 of these accounts - especially installment accounts. Your credit score could sky-rocket!
The challenging part? Finding the trusted person. Since you already have a low credit score and bad credit, how eager will someone be to make you a cardholder? Even your parents don't want you to damage their credit. But, no one says you need to possess the card! In other words, your trusted person could add you as a card holder and never give you the card or PIN or any information. Since the bills and all account information is still mailed to the trusted person's address, you won't know anything about the account. This scenario could land you many trusted persons. And you still benefit with a higher credit score.
4. Playing Round Robin
This strategy is one of the oldest credit building techniques around. It used to be accomplished with secured savings accounts. But now, it's much easier with secured credit cards. In fact, I've used this method myself.
Here's how it works: Take ,000 (or what you can afford) and get a secured credit card. Once received, get a cash advance of 70% of your credit limit. Get a second secured credit card. Once received, get a cash advance of 70% of your credit limit. Get a third secured credit card. Once received, get a cash advance of 70% of your credit limit.
Open a new checking account with the final cash advance. Use this account only for making payments on your three new credit cards. If you make your payments on time every month, your credit score will increase because you now have three new perfect payment credit cards. (Initially, your credit score might drop a few points due to the rapid, multiple accounts being opened. However, be patient because within 4 months of no new accounts or any delinquencies of any account, you will see your credit score increase. Mine increased 60 points in 60 days!!)
5. Pay on Time
This one is quite obvious. But after 12.5 years in the mortgage business, I discovered it still needs repeating. Your creditors were gracious enough to loan you money. Now pay your damn bills! If you don't, your credit score decreases. EVEN IF ONLY 30 DAYS LATE!
That's right folks. For some reason people think, "I'm only a few weeks late. What's the big deal?" Well, for the loan company, if you pay late but consistent, they make a lot more money with late fees and more interest (if a simple interest loan). For you, your credit score is damaged. If you think long-term and credit score, I'm certain you would not have a cavalier attitude.
6. Pay Down Debts
This seems like an obvious method, doesn't it? But it is not as transparent as you might think. Remember, we're playing with high-level statistics and probabilities which evaluates and forecasts trends in your behavior. Here's what you do...
Never pay off your revolving debt in it's entirety! Isn't that a surprise? Think about it. Your credit score is a reflection of your ability to manage your credit. Paying off your debt is not managing your debt. If you have a zero balance, how can you manage it? You don't. It no longer exists. And you cannot manage what does not exist, right? Therefore, in terms of credit score, you have demonstrated your ability to swiftly pay off accounts to avoid managing them. Thus, slightly decreasing your credit score.
One exception, of course, is if you're over extended to begin with. Pay off what's necessary to make your credit profile look great. Then manage the remaining credit.
[color=red:5cc07765c0][size=24:5cc07765c0]7. Don't Close Accounts [/size:5cc07765c0][/color:5cc07765c0]
[b:5cc07765c0]Even if you pay off revolving debts, do not close the account. The longer an account is open with no negative reports, the better it reflects in your overall credit score. This is due to the weighted-average in the credit score formula. Many credit experts suggest a balance of 30% of your credit limit. That's ideal. But you can go as high as 70% and still maintain a healthy credit score. [/b:5cc07765c0]
8. No New Credit
You must be vigilant in your credit behavior if you want the best credit score. Therefore, do not get any new credit unless it is absolutely necessary. Each time you apply for credit, an inquiry is added to your report. This usually drops your credit score slightly. When you have fresh credit, there is no track record how you will manage (or pay) this account. Therefore, it's a higher risk which results in a minor drop in your credit score. Remember, your credit score is about risk assessment.
Here's what you do: obtain credit for your housing, transportation, college or continued education and 3-5 credit cards. That's really all you need for personal credit. If you want more credit, request a credit limit increase on your current cards rather than apply for new ones.
9. Maintain A Mix of Credit Types
If you show you can handle different types of credit at the same time, you are rewarded with a great credit score. In other words, get installment loans like vehicle, personal loan or mortgage. Get revolving credit like credit cards: Visa, Mastercard, Sears, Sunoco Gas, Costco. By mixing it up, you demonstrate you can manage your credit because you will have short term and long term credit with a fixed payment. As well as a "variable" monthly payment on your credit cards.
Keep these accounts open with a balance of 70% or less and paid on time and you will witness your credit score climb to great heights.
10. Don't File Bankruptcy or Foreclosure
Here's the most obvious advice: Don't file for bankruptcy or foreclosure. These stay on your credit report for 10 years and always decrease your credit score. The older the bankruptcy or foreclosure account becomes, coupled with re-built credit history, the less of an impact they play on your credit score.
Contrary to popular beliefs, you can legally delete a bankruptcy and foreclosure. It's not easy. But it's possible. See the advanced methods for that solution.
To quickly rebuild your credit history after a bankruptcy or foreclosure, use the Round Robin strategy above and get secured credit cards. Now you can even get a car loan or mortgage right after bankruptcy.
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