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): (888) EXPERIAN (397-3742)
- Trans Union: (800) 916-8800
These agencies may charge you up to $8.00 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
How is a credit scoring model
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
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
How reliable is the credit
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.