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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.
New federal law allows consumers to receive a Free
Credit Report annually.
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 for a fee, contact the three major credit
reporting agencies:
- Equifax: (800) 685-1111
- Experian (formerly TRW): (888) EXPERIAN (397-3742)
- Trans Union: (800) 916-8800
These agencies may charge you up to $14..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.
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