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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. |
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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. |
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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): (800) 682-7654
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 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.
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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. |
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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.
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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. |
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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. |
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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.
Where can you get more information?
Consumer Response Center
Federal Trade Commission
Washington, D.C. 20580
202-FTC-HELP (382-4357);
TDD: 202-326-2502 |
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