Credit Scores: The Way They Are Calculated
Until a few years ago, Americans were kept unaware of such a thing as a credit score since it was tightly guarded by lenders. The reasoning was that the sophisticated mathematical formula, which evaluates all the information in credit report, would be difficult to understand for an ordinary person. The number, calculated by this formula, is used by lenders as a very accurate prediction of how much creditworthy the borrower is, i.e. how likely he/she is to pay their bills. Today consumers can obtain this information for free once every 12 months, or whenever they wish, paying a fee. The major credit bureaus that provide this credit reports are Equifax, TransUnion and Experian.
There are different credit-scoring models today that can produce different results. However, the most commonly used model is the FICO scoring method, with its score range of 300 – 850. The scores below 720 are considered low, while scores starting from 720 and higher are good enough to give access to a number of benefits, such as lower interest and insurance rates.
The FICO model generates the score by evaluating more than 20 factors in the following 5 categories:
- Payments of bills: 35% of the score;
- Amount of available credit and amount of money owed: 30%;
- Duration of credit history: 15%;
- Mix of credit – revolving credit (e.g. credit cards) with installment credit (e.g. mortgages): 10%;
- Applications for new credits: 10%.
The important thing to remember is that credit scores are not always perfect and may contain mistakes. This is why it is very important to check your credit report at least once a year; and you’d better do it 6-3 months before applying for a loan in case you are planning to buy a car or a house. This will give you the time to correct errors in your score (if there are any) before any lender pulls it.
Contrary to popular belief, the scoring model doesn’t take any of these attributes into account:
- Gender
- Race
- Age
- Income
- Job type or employment length
- Marital status
- Education
- If you’ve been turned down for credit
- How long you’ve been living at your current address
- If you rent or own a home
- Any other information not contained in the credit report
These factors, however, can be taken into consideration by a lender when making a decision on whether to approve your loan application or not.
