Importance of Credit Scoring

A credit score in is a number representing the creditworthiness of a person, the likelihood that person will pay his or her debts. Lenders, such as banks, credit card companies and mortgage lenders use credit scores to evaluate the potential risk posed by lending money to consumers.

The best-known and most widely used credit score model in the US is the FICO score. It is calculated based upon information from a consumer's credit files. It provides a snapshot of risk that banks and other institutions use to help make lending decisions. Applicants with higher FICO scores may be offered better interest rates on mortgages or automobile loans.

Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history. Although the exact formulas for calculating credit scores are secret, FICO has disclosed the following components:

• 35%: Payment history—Late payments on bills, such as a mortgage, credit card or automobile loan, can cause a FICO score to drop. Bills paid on time will improve a FICO score.
• 30%: Credit utilization—The ratio of current revolving debt (such as credit card balances) to the total available revolving credit or credit limit. Improved FICO scores can be had by paying off debt and lowering the credit utilization ratio. Alternatively, applications for and receiving the credit limit increase will also drive down the utilization ratio. The closing of existing revolving accounts will typically adversely affect this ratio and therefore have a negative impact on a FICO score.
• 15%: Length of credit history—As a credit history ages it can have a positive impact on its FICO score.
• 10%: Types of credit used (installment, revolving, consumer finance, mortgage)—Consumers can benefit by having a history of managing different types of credit.
• 10%: Recent searches for credit—Credit inquiries, which occur when consumers are seeking new credit, can hurt scores. Individuals shopping for a mortgage or auto loan over a short period will likely not experience a decrease in their scores as a result of these types of inquiries, however. While all credit inquiries are recorded and displayed on credit reports for a period of time, credit inquiries that were made by the owner (self-check), by an employer (for employee verification) or by companies initiating pre-screened offers of credit or insurance do not have any impact on a credit score.

There are other special factors which can weigh on the FICO score.

• Any money owed because of a court judgment, tax lien, etc. carry an additional negative penalty, especially when recent.
• Having one or more newly opened consumer finance credit accounts may also be a negative.

A FICO score is between 300 and 850, with 60% of scores near the right between 650 and 799. According to FICO the median score is 723.

Each individual actually has three credit scores for the FICO scoring model because the three national credit bureaus, Experian, Equifax and TransUnion, each has its own database. Data about an individual consumer can vary from bureau to bureau.

The NextGen Score is a scoring model designed by the FICO company for assessing consumer credit risk. In 2004, at the time of launch, FICO research showed an 4.4% increase in the number of accounts above cutoff while simultaneously showing a decrease in the number of bad, charge-off and Bankrupt accounts when compared to FICO traditional[13].

Each of the major credit reporting agencies market this score generated with their data differently:

• Experian: FICO Advanced Risk Score
• Equifax: Pinnacle
• TransUnion: Precision

Prior to the introduction of NextGen, their FICO-based scores were also marketed under different names:

• Experian: FICO or FICO II
• Equifax: BEACON
• TransUnion: EMPIRICA

Credit scores are often used in determining prices for auto and homeowner's insurance as well.

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