This is the ultimate guide to credit scores, but there’s always more you can learn in the process. I encourage consumers to examine the inner workings of the system and ultimately increase their understanding of credit scores.
Your credit score, in a nutshell, is the number that banks use to determine whether you qualify for credit. They use it to decide how much interest to charge and to calculate how much of a credit risk you present.
Factors at Play in a Credit Scoring System
A number of factors come together in a credit scoring system.
Higher scores indicate lower risk. This is rooted in the payment of past obligations, duration of credit history, amounts owed, and types of credit.
Say you are making monthly car payments. The timeliness and consistency of your payments will affect your credit score. In the financial service industry, consumers’ credit scores may vary based on the type of scoring model being used.
The score itself is generated from the consumer’s file at a consumer reporting agency (CRA). And at times, this is in conjunction with details of their credit application. The following information plays a role in determining the consumer’s score:
- Total debt
- Frequency and scope of late payments
- Number, type, and age of credit accounts
- Number of recent inquiries
Note: If you apply for multiple credit cards in a short period of time, multiple inquiries will be featured on your report.
Searching for new credit can be associated with higher risk. But most credit scores aren’t directly affected by multiple inquiries. There is no inherent reason to shy away from inquiring into mortgage, auto, or student loan lenders in any given period.
How does your credit score affect you?
In many cases, credit scores are the most important information regarding consumers’ credit files at a CRA.
They give lenders the details they need to determine whether a consumer is a promising candidate for a loan. In essence, the number of credit score points determines whether you’ll be offered credit, how much, and at what price.
The use of credit scores in deciding whether to extend credit — and in determining the terms of that credit — has increased significantly in recent decades. In the home mortgage business, over 90% of credit-card issuers and lenders rely on credit scores to make their lending decisions.
In short, credit scores predict the likelihood that consumers will engage in behaviors like delinquency, default, or bankruptcy. And since credit scores are based on the information in the credit file, they will change as the file is updated.
How accurate are credit scores?
Credit scores are indicative of the possibility of certain behaviors. But they cannot predict whether the consumer will actually engage in those behaviors.
This may come as a surprise, but lower-scoring consumers are actually more likely to avoid delinquency, default, and bankruptcy.
A study conducted by a Swedish scientist and a Federal Reserve researcher confirmed these findings. Swedish consumers with poor credit did not engage in negative behaviors. Of those with black marks on their credit report who received additional credit after the mark was removed, 24% defaulted again within two years.
Here’s another example that speaks to the accuracy of credit scores.
In 2007, at the beginning of the foreclosure epidemic, only 20% of mortgage borrowers with a credit score between 500 and 600 were seriously delinquent (more than 90 days late on their payment). Scores in this range, however, are considered poor.
And yet, since 600 is the cutoff to determine whether to grant a loan, most applicants who are denied credit would not have likely become seriously delinquent.
Of course, it’s important to acknowledge that for borrowers, the credit arrear (money owed that should have been paid earlier) may have been the result of a temporary factor such as illness or accident. It also could have been a simple mistake. These “trembles” are not necessarily indicative of the consumer’s credit risk. Yet lenders usually have a hard time making that distinction.
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Founder of TeachLegal
ABOUT THE AUTHOR
Shawn Smith is the founder of TeachLegal, where he helps readers educate themselves on personal finance, credit repair, debt solutions, and consumer law.
Shawn is an attorney representing clients in the Iowa District and Appellate Courts, Iowa Northern and Southern District Federal Courts, and the Northern and Southern District Bankruptcy Courts for the State of Iowa.