Credit scores in the United States are numbers that represent the creditworthiness of a person, the likelihood that person will pay their debts.
Lenders, such as banks and credit card companies, use credit scores to evaluate the risk of lending money to consumers. Lenders allege that widespread use of credit scores has made credit more widely available and less expensive for many consumers. Under the Wall Street reform bill passed in 2010, a consumer is entitled to receive a free credit score if they are denied a loan, credit card or insurance due to their credit score.
Credit scoring models
The FICO score was first introduced in 1989 by FICO, then called Fair, Isaac, and Company.The FICO model is used by the vast majority of banks and credit grantors, and is based on consumer credit files of the three national credit bureaus: Experian, Equifax, and TransUnion. Because a consumer’s credit file may contain different information at each of the bureaus, FICO scores can vary depending on which bureau provides the information to FICO to generate the score.
Credit scores are designed to measure the risk of default by taking into account various factors in a person’s financial history. Although the exact formulas for calculating credit scores are secret, FICO has disclosed the following components:
- Payment history (35%): Best described as the presence or lack of derogatory information. Bankruptcy, liens, judgments, settlements, charge offs, repossessions, foreclosures, and late payments can cause a FICO score to drop.
- Debt burden (30%): This category considers a number of debt specific measurements. According to FICO there are six different metrics in the debt category including the debt to limit ratio, number of accounts with balances, the amount owed across different types of accounts, and the amount paid down on installment loans.
These percentages are based on the importance of the five categories for the general population. For particular groups—for example, people who have not been using credit long—the relative importance of these categories may be different.
The makeup factors are limited to the individual’s past (and continuing) behavior on credit. Contrary to common misconception, other financial factors such as age, employment status, asset, income, etc. are not accounted. It, however, does not prevent lenders from asking and accounting these factors for particular lending considerations.
Getting a higher credit limit can help a credit score. The higher the credit limit on the credit card, the lower the utilization ratio average for all of a borrower’s credit card accounts. The utilization ratio is the amount owed divided by the amount extended by the creditor and the lower it is the better a FICO rating, in general. So if a person has one credit card with a used balance of $500 and a limit of $1,000 as well as another with a used balance of $700 and $2,000 limit, the average ratio is 40 percent ($1,200 total used divided by $3,000 total limits). If the first credit card company raises the limit to $2,000, the ratio lowers to 30 percent, which could boost the FICO rating.
There are other special factors that can weigh on the FICO score.
- Any money owed because of a court judgment, tax lien, etc., carries an additional negative penalty, especially when recent.
- Having one or more newly opened consumer finance credit accounts may also be a negative.