Understanding Credit Scores – the full story

Understanding Credit Scores

Recent media reports on changes in credit card legislation and tighter underwriting standards for lending have focused attention on credit scores as a measurement of credit risk.

As reported, banks and lenders are seeking to reduce their reserve requirements and risks by closing consumer credit card accounts, reducing credit line limits and/or raising rates. Taking actions such as these can have an unintentional effect of lowering consumers’ credit scores, affecting even those with a history of excellent scores and timely payments. A lower credit score can, in turn, hinder the consumer’s ability to get new credit and/or credit at an acceptable rate.

Credit scoring is used by lenders, insurers, employers, and landlords as a predictive model of credit risk. Included as a part of comprehensive tenant screenings, the credit score is a tool to help the landlord minimize the financial impact a bad tenant would impose on his business. The key is to understand the factors that comprise a risk assessment score and how changes in overall financial policies and regulations compounded by consumer choices can impact the score.

Reviewing the basics of credit scoring may be helpful to ensure your credit policies are adequate for your business in a changing and possibly difficult economy.

What is a credit score?

The mostly commonly used credit scores are FICO scores as developed by Fair Issac Corporation. There are actually three FICO scores, one for each of the three credit major credit reporting agencies – Experian, Equifax, and TransUnion.

Credit scores may be different at each credit reporting agency since the FICO score considers only the data in the credit report at that agency.

A credit score is calculated using a mathematical equation that evaluates information contained in the consumer’s credit file compared to patterns in millions of other credit files. The credit score number helps creditors assess consumer credit risk. It represents a snapshot analysis of a consumer’s credit history at a fixed point in time.

For a FICO score to be calculated the credit report must contain at least one account which has been open for at least six months and each report must contain at least one account that has been updated in the past six months.

A credit score is objective in that, by law, a score may not take into consideration race, color, religion, national origin, sex, marital status, receipt of public assistance, or the exercise of any consumer right under the Consumer Credit Protection Act. A credit score does not consider age, occupation, sources of income, employment history, residence, interest rates on credit accounts or family support obligations (unless support obligations are a matter of adverse public records).

While a Social Security number and date of birth are needed to order a scored credit report, this information, while identifying, is not factored in the credit scoring model.

Scores will and do change over time as consumers act and react to their specific financial events. Scores can be lower as a result of bankruptcies, judgments, liens, foreclosures, unemployment, increased credit card debt, and missed or late payments.

Credit scores will lag behind changes in the economy since it takes a while for the consumer’s credit actions to be reported and correspondingly rated. This is important to note because while your applicant may qualify now for tenancy with a high credit score, in reality, his score may become significantly lower as missed payments or higher spending amounts catch up to his record. In effect, if you were to run his credit again, you might find he could not qualify under your current credit standards. This is one of the reasons we recommend thorough tenant screenings and not simply rely upon just one number on which to base your rental decision.

FICO scores range from a low of 300 to a high of 850. The three digit number represents the degree of credit risk, i.e. the likelihood of repayment. The higher the score, the less of a credit risk.

There is no single magic cutoff number that major lenders use in their decisions to extend credit. This is a consideration that landlords should keep in mind in creating their own credit policies. In the past, the landlord, armed with his “magic number,” felt reasonably sure that applicants meeting that number were “good enough” for their selection as tenants. However, yesterday’s magic number may not be adequate in light of today’s shifting economy.

Minimum qualifying scores must take into account the potential applicant for the particular rental unit, the local market conditions, and the economy in general.

If your credit policy calls for a number close to “perfect” you may have set too high a standard and effectively limited your applicant pool. Those applicants who could have easily met that requirement in the past may now need to look elsewhere. This is particularly true at this time in history when many otherwise good tenants have had credit scores reduced through no fault of their own, as discussed above second paragraph.

5 Factors of a Credit Score

A FICO score takes into consideration the information contained in the credit file along with a generalized level of importance. The score is an analysis based upon the following five categories of information and the category’s degree of importance. The categories are:

• Payment history (approximately 35%),
• Amounts owed (approximately 30%),
• Credit history (approximately 15%),
• Types of credit (approximately 10%), and
• New credit (approximately 10%).

Account payment history is just that, payments on trade lines. This includes credit cards, retail accounts, installment loans, mortgage loans, and other lines of credit. In addition to current outstanding balances, late payments (delinquency) and the severity of delinquency (how long past due) are also factors. The number of past due items on an account is reviewed as well as the number of accounts that have been paid as agreed. Adverse public records and collection items have a negative impact on a credit score. Bankruptcy, judgments, suits, liens, and wage attachments are examples of adverse public records.

The credit scoring model looks at how much is owed on all accounts, how much is owed on specific types of accounts, the number of accounts with balances and how much available credit is shown for each account. The proportion of balances to total credit limits for revolving accounts and the proportion of balances to original loan amounts on installment loan accounts will be a consideration in the credit evaluation. In short, the more money that is owed compared to the credit limit, the lower the score will be.

In general, a longer positive credit history on an account will have a positive effect on a credit score. Length of credit history considers the time since accounts were opened, the specific type of accounts opened, and the time elapsed since account activity.

The type of credit is also a factor in a credit score. A mix of different credit types, credit cards, retail accounts, installment accounts, revolving accounts, mortgage loans, or personal lines of credit, etc. is considered in evaluating the overall credit risk. Too few accounts or too many of one type of account can indicate potential risk.

Recently opened accounts are given consideration as to the number of new accounts and the type of accounts. New credit inquiries, both the number of inquiries and the time period in which they were made, may also have an effect upon the credit score. Some credit bureau models also give consideration to the re-establishment of positive credit history after past payment problems.

Finally, we remind you that attention should be paid to other information on the credit report in addition to the credit score number. There are many things that can lower a credit score which should not necessarily disqualify an applicant. For example, a recent bankruptcy will certainly cause the score to be lower, but, depending on the details of the bankruptcy and other factors, may actually indicate a preferred applicant because a tenant without a bankruptcy on record can file for one at any time whereas one with one on record cannot file again for many years after the previous filing.

About the Author

YouCheckCredit.com has been providing online credit reports and background checks since 2000. If you have any questions, we can be contacted at YouCheckCredit.com, 3822 Campus Drive #200, Newport Beach, California. Toll Free number 1-866-666-8833 or Articles@YouCheckCredit.com