How Do Credit Scores Work?
Credit Scores are used by most creditors, and we’re being marketed to, almost on a daily basis, to watch our credit scores closely (ie, free credit scores, credit monitoring, alerts, etc.), but why? Why do credit scores matter and how do they work?
Why Credit Scores Matter
Most financial institutions and creditors rely on credit scores to make fast pre-qualifications and approvals/disapprovals for new credit applicants. This helps break down and speed up the approval process in order to quickly and easily select only those who are in a specific range (credit score, based on points).
Some credit card companies may have a point range that they look for during certain times of the year (ie, Holidays when shopping skyrockets), which will help eliminate applicants who may be more of a risk, based simply on bad credit scores.
For example, if you have a TransUnion Credit Score of 602 and you apply for a specific credit card, their credit scoring factors may be looking for someone with a 610 or higher, which means you would be rejected. Of course, this is just an example and you may very well be approved for the card you’re applying for with that score.
Every credit reporting agency (CRA, also known as credit bureau) have their credit scoring system based on your credit history. Revolving credit may be worth a higher percentage of your score with one agency, whereas it may be worth much lower at another CRA.
Credit scores can be the sole reason of why you get approved or denied for that new car, or why your interest rates jump when you apply for the new home you have been wanting. They can also play an important part in factoring in your deposit or down payment, as well as the APR/percentage you may need to pay back on the loan.
OK, well, that credit score can also hurt your chances of your dream job, insurance or even the apartment that you have to move into if you get denied for that dream home you wanted.
Credit scores matter.
How Credit Scores Work
As stated above, every CRA has their own scoring system. These scores utilize the data from your credit history, meaning that all accounts, inquiries, etc. will factor into the credit scores.
The bureaus (CRA’s) use mathematical algorithms to formulate a score based on the information within your credit report.
What this means is that these scores attempt to, as accurately as possibly, calculate and predict the likelihood of you paying your bills on-time, each and every month. They use many different factors, although these factors are all use different percentages to make up the exact score.
What is FICO
All 3 major CRA’s use a scoring system based on FICO. FICO stands for Fair Isaac Corporation, founded in 1956, and uses scoring from 300 to 850 points, with 850 being perfect and 300 being extremely poor. The scoring method was created to determine and evaluate creditworthiness, so that companies could approve or deny credit applicants in a much easier and more realistic manner. FICO later developed software to automate the system and processes, which is when the 3 biggest CRA’s started using FICO scores.
While the CRA’s have all used a similar system, all of their scores will most likely differ from each other based on different algorithms that are used to conduct these scores.
TransUnion’s method for scoring is called the EMPIRICA score, while Equifax uses a system called the BEACON score. Experian uses something called the Experian/Fair Isaac Risk Model.
Below is a list of 5 categories that are used to determine FICO credit scores, based on general importance and a “weighted calculation.”
EXAMPLE OF The Breakdown of A FICO credit score:
Payment History: 35%
Credit History length: 15%
New Credit: 10%
Type of credit used: 10%
What Is VantageScore
The VantageScore method was developed together, in collaboration, by all 3 bureaus (Equifax, Experian and TransUnion) in an attempt to compete with Fair Isaac’s FICO scoring system. It was released in 2006.
This proprietary credit scoring model is proposed as a more accurate score for consumers, although the CRA’s continue to share the FICO score with lenders, too.
Unlike FICO, all 3 CRA’s use the same algorithm to calculate the VantageScore. While they all use the same information and even algorithm, there may still be discrepancies based on the differentiating data that is used by each credit reporting agency.
In other words, you may see that you have 3 different VantageScores by the different bureaus. This could be due to slightly different data that has been reported by creditors to each bureau, although this is not always the case.
VantageScore Calculations are somewhat similar to FICO, but let’s look at the differences.
Scoring: VantageScore goes from 501 to 990, whereas FICO goes from 300-850.
While we don’t know exactly how the scoring will be calculated, there are categories that have been released by VantageScore that will help us gain a better understand the effects of the scoring process.
- Payment history: Have you paid your bills on-time, each billing cycle?
- Credit Utilization: The total amount of credit you’re using (ie, debt-to-credit ratio)
- Balances: Total debt of current and past-due/delinquent accounts on file
- Depth and History of credit: Length of credit history, mix of loan/credit types, etc.
- Recent credit: All new credit accounts as well as inquiries (hard pulls).
- Available credit: Total amount of credit available to you, today. (ie, $5,000 credit card and $10,000 personal loan)
VantageScore also utilizes a letter grade scale as well.
(Note: this is based on the old scoring system. VantageScore now uses a scoring range of 300-850)
- “A” for scores between 900-990
- “B” for scores between 800-899
- “C” for scores between 700-799
- “D” for scores between 600-699
- “F” for scores 599 and below
If you score an “A”, this means you are a less risky applicant for credit, whereas an “F” would be very risky.
When it comes to scoring, VantageScore does not take into consideration any of the following:
- Living Location
- Salary/Occupation/Employer or Employment History, as well as title
- Marital status
VantageScore may be used by many different financial institutions, such as banks, lenders or credit card companies to determine whether or not whether you’re a risk factor or not, as well as figuring out the terms of the loan, down payment, deposit and APR/rates.
Credit scores play an important part in every consumers’ lives. They can affect your livelihood in many ways, so it’s always best to pay close attention to your credit score and monitor them (any or all 3) each month to see if there are any changes, negative or positive.
There are a lot of factors that go into creating your credit scores. Payment history, Balance of accounts, credit history/depth, new credit, credit utilization and available credit can cause an increase or decrease in your score, thereby affecting your chances of getting a new loan or even a job.
These scores are created by using an algorithm (mathematical formula) utilizing the above information. The scores will help determine your creditworthiness or risk factors for lenders and creditors who you apply with. They can also be used to simply ‘pre-qualify’ you before attempting a hard pull.