What is credit scoring?

Credit scoring is a system used to help determine whether to give you credit. Information about you and your credit experiences, such as your bill-paying history, the number, type, and age of your accounts, late payments, collection actions, and outstanding debt is collected from your credit application and your credit report. Using a statistical program, creditors compare this information to the performance of consumers with similar profiles. A credit scoring system awards points for each factor that helps predict who is most likely to repay a debt. The total number of points - a credit score - helps predict how worthy you are; that is, how likely it is that you will repay a loan and make the payments when due. As your credit report is an important part of many credit scoring systems, it is very important to make sure it's accurate before you submit a credit application. To get copies of your report, contact the three major credit reporting agencies:

Equifax
P.O. Box 740241
Atlanta, GA 30374-0241
(800) 685-1111

Experian
P.O. Box 2104
Allen, TX 75013
(888) EXPERIAN (888-397-3742)

Trans Union
P.O. Box 1000
Chester, PA 19022
(800) 916-8800

These agencies may charge you up to $9.00 for your credit report.

Why is credit scoring used?

Credit scoring is based on real data and statistics, so it usually is more reliable than subjective or judgmental methods, as it treats all applicants objectively. Judgmental methods typically rely on criteria that are not systematically tested and can vary when applied by different individuals.

How is a credit scoring model developed?

To develop a model, a creditor selects a random sample of its customers, or a sample of similar customers if their sample is not large enough, and analyzes it statistically to identify characteristics that relate to creditworthiness. Each of these factors is then assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its own credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company. Under the Equal Credit Opportunity Act, a credit scoring system may not use certain characteristics like race, sex, marital status, national origin, or religion as factors. Creditors are allowed to use age in properly designed scoring systems, but any system that includes age must give equal treatment to elderly applicants.

What can I do to improve my score?

Credit scoring models are complex and often vary among creditors and different types of credit. If one factor changes, your score may change - but improvement generally depends on how that factor relates to other factors considered by the model. Only the creditor can explain what might improve your score under the particular model used to evaluate your application. Nevertheless, scoring models generally evaluate the following types of information in your credit report:

Have you paid your bills on time?
Payment history is typically a significant factor. It is likely that your score will be affected negatively if you have paid bills late, had an account referred to collections, or declared bankruptcy.
What is your outstanding debt?
Many scoring models evaluate the amount of debt you have compared to your credit limits. If the amount you owe is close to your credit limit, it is likely to have a negative effect on your score.
How long is your credit history?
Generally, models consider the length of your credit track record. An insufficient credit history may have an effect on your score, but that can be offset by other factors, such as timely payments and low balances.
Have you applied for new credit recently?
Many scoring models consider whether you have applied for credit recently by looking at inquiries on your credit report when you apply. If you have applied for too many new accounts recently, that may negatively affect your score. However, not all inquiries are used; inquiries by creditors who are monitoring your account or looking at credit reports to make prescreened credit offers are not counted.
How many and what types of credit accounts do you have?
Although it is generally good to have established credit accounts, too many credit card accounts may have a negative effect on your score. In addition, many models consider the type of credit accounts you have. For example, under some scoring models, loans from finance companies may negatively affect your score .

Scoring models may be based on more than just information in your credit report; the model may consider information from your application as well. These could include: your job or occupation, length of employment, or whether you own a home. To improve your credit score under most models, concentrate on paying bills on time, paying down outstanding balances, and not taking on new debt. It's likely to take some time to improve your score significantly.

How reliable is the credit scoring system?

Credit scoring systems enable creditors to evaluate millions of applicants consistently and impartially on many different characteristics, but to be statistically valid, credit scoring systems must be based on a sufficient sample. Remember that these systems generally vary from creditor to creditor. Although you may think such a system is arbitrary or impersonal, it can help make decisions more quickly, accurately, and impartially than individuals when it is properly designed. Many creditors also design their systems so that in marginal cases, applicants whose scores are not high enough to pass easily or low enough to fail absolutely are referred to a credit manager who decides whether the company or lender will extend credit. This may allow for discussion and negotiation between the credit manager and the consumer.

What happens if you are denied credit or don't get the terms you want?

If you are denied credit, the Equal Credit Opportunity Act requires that the creditor give you a notice that tells you the specific reasons your application was rejected, or the fact that you have the right to learn the reasons if you ask within 60 days. Indefinite and vague reasons for denial are illegal, so ask the creditor to be specific. Acceptable reasons include: "Your income was low" or "You haven't been employed long enough." Unacceptable reasons include: "You didn't meet our minimum standards" or "You didn't receive enough points on our credit scoring system." If a creditor says you are denied credit because you are too near your credit limits on your charge cards or you have too many credit card accounts, you may want to reapply after paying down your balances or closing some accounts. Credit scoring systems consider updated information and change over time. Sometimes you can be denied credit because of information from a credit report. If so, the Fair Credit Reporting Act requires the creditor to give you the name, address, and phone number of the Credit Reporting Agency that supplied the information. You should contact that agency to find out what your report said. This information is free if you request it within 60 days of being denied credit. The CRA can tell you what's in your report, but only the creditor can tell you why your application was rejected. If you've been denied credit or didn't get the rate or terms you requested, ask the creditor if a credit scoring system was used. If so, ask what characteristics or factors were used in that system, and the best ways to improve your application. If you receive credit, ask the creditor whether you are getting the best rate and terms available and, if not, why. If you are not offered the best rate available because of inaccuracies in your credit report, be sure to dispute the inaccuracies in the report.

Federal Trade Commission Consumer Protection

http://www.ftc.gov/bcp/menu-credit.htm

Fair Isaac FICO Scoring

http://www.myfico.com/

Source: http://www.business.gov/phases/launching/finance_startup/credit_scoring.html