Credit Scores: How They Generally Work

The mathematical credit score generated by Fair Isaac or other modelers is done on the fly. The code is based on credit data within the consumer's credit file at the time the credit grantor requested the credit file. The score and the adverse reason codes generated is based on a mathematical formula. This code looks at each individual tradeline, comment, inquiry, and public record within each of the repository databases and calculates a number/score. Today credit scoring is the preferential choice of lenders as it provides a quick way to grant or deny credit. Modelers design them typically, to rank the likelihood that an applicant will go ninety days delinquent on any consumer credit loan or account within the next two years generally.

The credit score gets points added for many positive items and gets points deducted for negative items. These negative items can be late payments, collections, inquiries, accounts listed in bankruptcy, charge offs, tax liens, foreclosures, and high balances on credit cards just to name a few.

The lending industry has many different types of credit scores on the market today. Many different vendors have created them, such as Fair Isaac, the three national repositories, credit grantors, and insurance companies. Lenders use two types of credit scores generally. First, many rely on generic credit scores based on an applicant's credit file. Second, custom and behavioral scores designed by lenders that use their own statistical analysis and data based on their present and past customers and on their own individual needs.

While each lender has different credit criteria, several basic rules of thumb in scoring apply too almost every credit-scoring model. Each version is different based on criteria set by each of the separate national repositories, Fair Isaac, credit grantors, and others in the mortgage arena, primarily lenders have viewed Fico scores below 620 as too risky. This will cause the consumer to be denied credit, suffer sub-prime rates, or other adverse terms. Additionally, the consumer's past payment history is the largest factor considered by scoring models.

The Fico model credit score, which is used by 75 percent of lenders, is based entirely on information in a consumer's credit report. The scoring range for the Fico classic model is 300-850. The higher the credit score, the less risky the consumer is viewed by creditors. Consequently, consumers with the higher credit scores usually above 720 often can obtain the most favorable rates for mortgages, refinancing, personal and auto loans and auto and homeowners insurance. They also receive loans with less or zero down payments, and can have higher DTI ratios (debt to income ratios), and also often receive solicitations for the best quality credit cards. Conversely, the lower the score, the less favorable the rate and terms are for the consumer.

For example, on a $ 250,000 30-year, fixed-rate mortgage, a consumer with a 720 score might pay a 5.5% interest rate with a monthly payment of $ 1,419, while a consumer with a 619 score would pay an 8.5 0% rate with a monthly payment of $ 1,922. The difference in payment is $ 503 per month, or $ 6,036 per year, or $ 181, 021.00 over 30 years. Consumers having too low of a Fico score can be disqualified for most, if not all, loan programs and options for major credit transactions like real estate mortgages. Similarly, the existence of certain types of derogatory information in the credit report, including unpaid bills, or collections, can make the consumer a higher risk and ineligible for major credit.

Like the credit reporting industry, there is even lower public awareness about credit scoring. A September 2004 survey by Opinion Research Corporation Intl. sponsored by the Consumer Federation of America (CFA) and Providian Financial, a major credit card issuer, found that:

Few consumers know what constitutes a good score. Only 12% correctly identified the low 600s as the level below which they would be denied credit or have to pay a higher sub-prime rate. (One-third thought this level was the low 500s, and 30% said they didn't know.) And, only 13% correctly understand that scores above the low 700s usually qualify them for the lowest rates.

The Fair Isaac scoring models (also called generic credit scores) are the industry standards. Experian's Fico score is called a "Fair Isaac" score, TransUnion Fico score is called an "Empirica" score, and Equifax's Fico score is called a "Beacon" score. On their website, Fair Isaac discusses the five main categories that they use in their statistical model. The five areas and percentage of weight each area generally carries are:

1. Payment history - 35 percent

2. Amounts owed - 30 percent

3. Length of credit history - 12 percent

4. New credit - 10 percent

5. Types of credit used - 10 percent

Behavioral scores are quite different and distinguished from generic and custom scores because they use only their current consumers. Behavioral scores are used to cross-sell products to existing borrowers. For example, a lender may use their own score, which they have generated from their mortgage portfolio. They then select borrowers for new offers like a new credit card, insurance, or any other product they may have. Another important use of behavioral scores is in collecting delinquent accounts. Consumers with poor behavioral scores are contacted earlier than consumers with higher behavioral scores.

Source: Elkins v. Ocwen Fed. Sav. Bank Experian Info. Solutions, Inc., 2007 U.S. Dist. LEXIS 84556, (N.D. Ill. 2007).