Credit Scoring Basics

I decided to write this blog article on credit scoring after noticing the number of questions I got about this topic from family and friends. Demystifying credit scoring is an important part of your financial health and this article will get you started. I will be compiling a whole series on credit that will cover various topics in-depth.

What Is Credit Scoring?

Simply put, credit scoring is one method banks use to measure credit risk in consumer lending. Since credit scoring is all about risk prediction it is important to remember that the score is only focused on ensuring banks can adequately price risk. It is important to keep this in mind as at times actions that may increase your credit score may not be in your best interest.

A Word of Caution

The most popular model for Credit Scoring was invented by Fair Issac and is marketed under the FICO brand. Since FICO scoring is the most popular model used in the consumer lending space the advice in this article will be focused on information geared towards the FICO scoring models. Alternative models, often regarded to as FAKO, won’t be discussed due to there being no real way of knowing what the model consists of.

Although the majority of consumer lending institutions use FICO scoring when determining your interest rate they are allowed to customize the model. As a result, your credit score can vary from institution to institution even without any material difference in your credit report.

What Is A Credit Score Composed Of?

According to Fair Issac a FICO Score is composed of the following weighted components:

Weight Category Note
35% Payment History Late payments and collections
30% Amounts Owed Your utilization – How close your balances are to your credit limits.
15% Account Age Your Average Age of Accounts.
10% New Credit How often you’ve sought credit.
10% Types of Credit How diverse your types of credit are – such as having a mortgage and credit cards.

FICO scores range from 350 – 850, with a score above 700 generally considered as “good” credit.

Payment History

This is the most important component of a credit score. It is also the hardest to change as the only cure for a poor payment history is time. As such, the most important thing to do to obtain and maintain good credit is to make on-time payments to any lenders you have. This seems to go without saying, but many people don’t understand the disastrous impact a single late credit card payment can have on their credit score and borrowing costs.

According to the Fair Credit Reporting Act negative information needs to be removed in the time frames specified in the below chart:

Negative Information Type Time to Removal Note
Late Account (Non-Medical) 7 Years The time is based on “date of first delinquency” not when it appeared on the report.
Medical Collections 10 Years
Public Records 10 Years Chapter 13 Bankruptcy is 7 years.
Tax Liens 15 Years

Positive information for active accounts can remain on your report indefinitely and closed paid accounts can remain for up to 10 years.

Utilization (Amounts Owed)

The second most important factor affecting your FICO score is your credit utilization. FICO scoring models look at both your overall utilization as well as your per card utilization. Ideally, you want to keep you utilization lower than 10% overall and individually to maximize your score.

There are a few important factors to know about utilization. The first is that it is not historically tracked so there is no need to follow this number until you are actively seeking credit. If you have high utilization and you’re actively seeking credit the easiest and biggest score boost will come from lowering your utilization. Another important factor for utilization is to be aware that it is tracked by the statement balance reported on your credit card statement. This is very important because if you’re like me and pay off your card balance every month you won’t get any extra points for doing so. FICO doesn’t care if you pay off 100% of your balance monthly or only pay the card minimum. Although this seems counter intuitive it makes sense. Remember, FICO is all about predicting your risk of default in the future. In that regard, having a large amount of liabilities are a risk. A job loss could theoretically ruin you.

Average Age of Accounts

Average age of accounts is a measure of how old your credit scoring data is. This is not the same age as your credit file itself. The older your credit scoring data the bigger the boost you’ll get from this component. Of course, the whole reason for this is to give more weight to reports that span a larger share of the user’s credit life.

Inquiries (New Credit)

Every time you actively seek new credit (such as applying for a credit card or mortgage) you’ll take a slight credit score hit. This hit will come from increased inquiries and can drop your score as much as 10%. All inquiries sit on your credit report for 2 years.

Due to the impact of applying for new accounts it is best to hold off on any new credit applications for 6-12 months before seeking any major loans (such as a mortgage). Failure to do so may result in a lower score at the time of application forcing you to incur higher borrowing costs or be declined altogether.

Account Mix (Types of Credit)

FICO scoring prefers you to have a mix of credit types, such as mortgage loans and credit cards. This is one of the smallest factors in your credit score and I don’t recommend seeking the perfect mix. You shouldn’t borrow money, especially in large fixed installment loans (like a mortgage), solely for credit scoring benefits. Without the right mix you may never reach a 850 score, but if you manage the other components you’ll have a score high enough to keep your borrowing costs low.

Resources

Resource Note
My FICO Fair Issac MyFICO consumer site
FICO Community MyFICO Community Forums
Credit Boards Credit Boards credit information forum

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