How Do Credit Scores Work?

Everyone says that your credit score is one of the most important pieces of financial information available. Your credit score is basically a numerical representation of the information in your credit report. All of the information in your credit report is assigned some sort of value, and then weighted. Then using mathematical formulas, all of that information is reduced to a single number. This single number allows lenders, insurance companies, and even some TV service providers to – with a single glance – get an idea of what sort of credit risk you represent. If you have a high credit score, you are considered a low risk, and you are likely to be approved for services with favorable terms. If your credit score number is lower, you are likely to be viewed as a threat of default. For those who aren’t denied outright, the penalty is often paying a higher cost.

While the exact formulas used to determine your credit score are considered proprietary information, it is still possible to learn a little bit about different credit scoring systems, and get an idea of how they measure you.

FICO: The Most Common Credit Scoring Model

The most common credit scoring models you run into are based on the score developed by the Fair Isaac Company: the FICO score. If you visit www.myFICO.com, you will find that the FICO score is, at its most basic, weighted according to five different factors:

  1. Payment History: This is whether or not you make your payments on time, and includes reports of missed payments from non-credit entities, like utility companies and landlords. Your payment history accounts for 35% of your FICO score.
  2. Credit Utilization: How much money you owe matters. This looks at how much money you owe, and also considers how much you owe as a percentage of the available credit you have. The more you owe, the lower your credit score. Your credit utilization accounts for 30% of your FICO score.
  3. Length of Credit History: There are two considerations with your credit history. FICO considers how long you have had a loan of any kind. Also considered in the formula is the average age of your loans. So, the length of time you have had each of your loans is added up and divided by the total number of loans to get an average. The longer your history, the better your credit score. Your credit history accounts for 15% of your FICO score.
  4. New Credit: Have you applied for a new credit account lately? Have you taken on new debt? Both of these factors figure into the “new credit” portion of your credit score. If you are applying for more credit, or if you have just opened a new loan account, it can send your FICO score a little bit lower. Your new credit accounts for 10% of your FICO score.
  5. Types of Credit You Have: Finally, the FICO credit scoring model considers the different types of loans you have. It looks at credit cards (and whether they are issued by a major bank, or by a department store), mortgages, auto loans, payday loans and other types of credit. Payday loans count heavily against you in this section of the formula, while major bank issued credit cards are generally considered positive. The scoring model recognizes the importance of having a mix of installment loans, which are paid off on a regular schedule, and revolving loans, which – like credit cards – are open accounts that allow you to keep borrowing as long as you haven’t reached your limit. The types of credit you use accounts for 10% of your FICO score.

Your FICO credit score range is between 300 and 850. What score will earn you the best interest rate depends on the credit climate. Before the financial crisis of 2008, credit was easy to get, and you could get good terms with a credit score of 680 or above. Now, however, many lenders want to see a score of at least 720 before offering the best interest rates. Using the FICO scoring model, the quality of your credit is generally judged as follows:

  • Excellent: 760 and above
  • Great: 700 – 759
  • Good: 660 – 699
  • Average: 620 – 659
  • Poor: 580 – 619
  • Very Poor: Below 579

It is important to note that FICO scoring isn’t consistent from lender to lender – or even from credit bureau to credit bureau. Lenders and credit bureaus introduce their own tweaks to the model in order to help them emphasize items that are more important to them. Additionally, since each credit bureau might have different information about your financial situation, the scores you get from each bureau vary. The TransUnion FICO score only uses information that is based on what is in a TransUnion credit report, and the Equifax FICO score only makes use of what is in its own report. (Experian no longer uses the FICO model as a base for its scoring system.)

FICO itself tweaks its own scoring model from time to time to emphasize different attributes. The latest change, which is just now being adopted on a wider basis, is the FICO 8 scoring model, which was introduced in 2009. Some of the changes to the scoring formula include:

  • Less emphasis on isolated late payments. If you normally pay on time, one late payment won’t be as damaging to the payment history portion of your FICO score.
  • Increased emphasis on credit utilization. For those closer to the credit limit on their credit cards, FICO 8 includes a bigger negative impact in the appropriate portion of the formula.
  • Small balance collections will no longer be considered as part of the FICO score unless they have a balance of at least $100.

On top of changing the base FICO score periodically, FICO offers a number of specialized tweaks. FICO’s mortgage score is designed to help home lenders get a score that focuses more on your payment history with home loans and other long term, large obligations. Auto lenders can use a FICO score tweak that offers greater weight to your payment history with car loans. The variations are endless. However, since most credit scores are based, in some way, on the basic FICO score model, focusing on the five categories offered by FICO as its basis can help you build a good credit score – no matter what variation of the FICO scoring model is being used.

FICO Expansion Score: One of the complaints about the FICO scoring model is that it doesn’t take into account responsible financial habits that aren’t related to borrowing money. Indeed, the credit score model is designed to encourage a certain amount of debt. Financially responsible consumers who don’t want to borrow are penalized under the credit scoring system, since they aren’t establishing credit. Later on, if they decide to borrow for a home, or if they want insurance, their lack of borrowing history can lead to higher interest rates or insurance premiums.

In order to help remedy this, FICO created the Expansion score. It includes payment actions such as utility bills, insurance premium payment, purchase payment plans, and rent payments. These are items that normally do not appear on your credit report – and are therefore not included in your credit score – unless you miss a payment. You aren’t rewarded for behaving responsibly in these non-credit situations. The FICO Expansion score incorporates these items into a scoring model. However, it also includes bank account activity, so a bounced check or multiple overdrafts on your checking account can negatively impact your credit score.

So far, adoption of the FICO Expansion score has been fairly slow. However, some lenders might consider looking into the FICO Expansion score for those trying to establish their credit history. One alternative credit reporting agency, the PRBC reporting agency, uses the FICO Expansion score to help financial services companies make decisions. This agency is set up to create a consumer report based on non-credit activities. However, if you want your information reported to PRBC and included in its report, you will have to pay a fee and convince insurers, landlords, utility companies and banks to report your information.

PLUS Score: Experian’s Scoring Model

FICO sells credit scores to lenders. Experian, on the other hand, does not sell – to lenders, anyway – the score it has developed using data in the Experian credit report.  Instead, Experian markets and sells its PLUS score to consumers as a way to learn more about their own credit. The factors that the PLUS score considers include payment history, credit usage, new credit applications, types of credit use, number of credit inquiries, current level of debt and other factors. This scoring model starts 330 and runs to 830, presenting a smaller range.

Experian’s PLUS score also comes with a look at where you rank among other credit users, available with the accompanying PLUS Report. You are put in a percentile. If you are in the 85th percentile, it means that your credit score is better than 85% of the public. Because Experian has access to all those credit reports, the data it compiles is fairly accurate.

VantageScore: Competing with FICO

Experian’s PLUS score doesn’t compete directly with the FICO score, since Experian sells its PLUS score only to consumers. However, Experian had a hand in creating the VantageScore, which is meant to compete with FICO, although the model has yet to gain much ground against FICO. The VantageScore was developed by all three credit bureaus. The VantageScore model also breaks down factors that go into the score differently to FICO:

  • Payment History: Whether you pay on time or miss payments. This accounts for 32% of your VantageScore.
  • Utilization: How much of your available credit is already used. This accounts for 23% of your VantageScore.
  • Balances: The actual amount of your credit balances. This accounts for 15% of your VantageScore.
  • Depth of Credit: This includes how long you have had credit, and how old your accounts are. This accounts for 13% of your VantageScore.
  • Recent Credit: How many accounts have been opened recently. This is figured as 10% of your VantageScore.
  • Available Credit: The amount of credit you have available to you is also considered as part of the VantageScore, amounting to 7% of the formula.

Recently, VantageScore began including rent payments in payment history. If your landlord reports good payment habits, it can impact your VantageScore. (It also positively impacts your PLUS score, since Experian is the first major credit bureau to start including regular rent payments – rather than just reports of missed rent payments – in a credit scoring model.) The VantageScore model features a scale from 501 to 990, and the quality of your credit is expressed as a letter “grade”:

  • A: 900 – 990
  • B: 800 – 899
  • C: 700 – 799
  • D: 600 – 699
  • F: 501 – 599

Unlike the FICO score, which is constantly being tweaked and adjusted a little at a time to reflect changing conditions or reflect the preferences of different financial services providers, the marketers of the VantageScore point out that this newer scoring model is uniform, and provides a simple letter grade as an overview of someone’s creditworthiness.

ChexSystems

While ChexSystems does not have a specific scoring model, it can affect your finances. However, it is a reporting agency that you should be aware of. ChexSystems acts as a reporting agency for banks. Banks involved with ChexSystems report negative behaviors to the company. This negative behavior can include bounced checks, repeatedly overdrawing your account, improperly closing an account you no longer want to use, or depositing fraudulent checks.

Basically, if your bank reports to ChexSystems, you remain in the system for five years. During that time, if you try to open an account at another bank that uses ChexSystems, you might be denied. It’s not exactly a score, but it does impact your ability to establish banking relationships and open new accounts. It is something you need to be aware of, even though a ChexSystems incident will not affect your regular FICO score or your VantageScore.

Other Credit Scoring Models

There are other companies that provide credit scores based on different models. However, these models are not used very widely, and are often considered niche scoring models. Some of these credit scores include:

  • CreditXpert: This score is developed by the software company CreditXpert. It uses its own model based on the information in the credit reports offered by the three major credit bureaus. The scale runs from 350 – 850, and includes your payment history, account balances, length of credit history, number of credit applications, and your credit usage.
  • Community Empower: Also spanning a scale of 350 – 850, the CE score looks at information with an emphasis on home ownership. Community Empower is a counseling network designed to help potential homeowners learn about buying and owning homes. The score is used to help potential homeowners learn about credit. The score includes payment history, credit and loan balances, requests for credit, types of credit accounts, number of credit accounts, and the number of new accounts opened.
  • TransRisk: This is a little used score developed by the credit bureau TransUnion to assess the type of credit risk consumers represent. The scale runs from 300 to 850. Rather than being based on FICO, it is an independent score developed using only TransUnion credit report data. It includes payment history, outstanding debt, credit account history and recent inquiries, and the types of credit accounts you have.

It is also worth noting that the credit bureaus might also have a different score that they provide for you, and one that is provided to financial services companies interested in your score. One of the biggest issues is that even though you can get a general idea of the factors that make up your credit score, you can’t get access to the exact formula.

Getting Your Credit Score

If you are interested in your credit score, you will have to ask for it – and you will probably have to pay for it as well. You are not entitled to see your credit score the same way you are entitled to a free credit report every year. If you want to see your credit score, you can visit the company that provides the scores, and specify which score you want. Here are some of the common web sites to visit in order to purchase your credit score:

  • MyFICO: You can go to www.myfico.com to get your FICO score. You can also purchase your TransUnion or Equifax FICO score from this web site. Be aware that this score may not reflect the score that lenders see, but it will give you a general idea of where you stand.
  • TransUnion: Visit www.transunion.com to get a version of your TransUnion FICO score, your TrasRisk score or your VantageScore.
  • Equifax: Go to www.equifax.com for your Equifax FICO score, or for your VantageScore.
  • Experian: You can access your PLUS score, or get a copy of your VantageScore from www.experian.com.

In most cases, you will have to pay between $5.95 and $14.95 for each credit score. Starting in July 2011, if you are denied credit or if your insurance premium goes up due to your credit score, you have to be provided with the company that provided the score or with the credit score model used. You are also entitled to a free copy of the credit score if you write to request it within 60 days.

You can also check certain credit scores by going to websites that provide the service, but be wary of sites that charge you to see your free credit score. If you remember to cancel your subscription before the end of the free trial period, it can be worth it. Otherwise, you might find yourself paying a great deal for a service you don’t want or need.