Credit Score

  • What is a Credit Score
  • A credit score is a predictive metric that is used by banks, credit unions, and insurance companies to try and predict the ability of a person to meet a certain financial obligation. By looking at past history, uses specific indicators of financial capacity to determine the probability of a delinquency in 90 days, based on the last 24 months’ worth of information available. From there, the score itself is adjusted based on the different types of debt that an individual has taken.

    This means that, at any given time, and individual actually has more than one credit score tied to them, depending on how many different types of debt they’ve taken on during their life. What’s more, because many companies also maintain proprietary credit scoring systems of their own, an individual’s scores on different products will also have a variety of subscores from different companies.
     
    While this description clearly illustrates the complexity of credit scoring, it is important to remember that there are a number of key fundaments that create all of these individual scores. It is by understanding these fundamentals that we can begin to get an understanding of how it is a credit score is generally built, improved, destroyed, or even simply maintained.

    This simplification is made even more accessible when we take into account the fact that a “FICO” credit score acts as a somewhat universal standard for evaluating credit, and can therefore provide a very clear picture of these fundamentals on its own. Granted, our analysis will be very general in comparison to the in-debt statistics that are conducted to create a full evaluation, but I will allow us the opportunity to look at what aspects of a credit score have the greatest impacts on our lives.
     

  • How Does FICO Measure Creditworthiness?
  • A FICO score represents an individual’s fundamental creditworthiness. While it is often combined with a particular lender’s proprietary modeling, FICO has served as the key determinant of an individual’s score for decades. As mentioned before, it measures an individual’s ability to maintain solvency over a 90-day period, based on the last 24 months from the date of the check.

    It then measures that capacity for repayment on a scale between 300-850 points. On average, Americans hold a score of 723 as of the year 2010. This range is then broken up into different cut-off ranges to generally classify borrowers at a glance.

    Score: N/A

    Rating: No Credit.

    Description: This rating is reserved for individuals with no credit history. It isn’t necessarily a bad thing to have no credit, it simply means that the individual in question needs to work on establishing themselves with a rating. This may occur because an individual has recently come of age, or is a recent immigrant.

    Types of Credit Available: Individuals without credit will generally be looked upon cautiously by lenders. As such, security is usually required, or low-limits will be imposed on those debts that are issued without collateral. For interest rates, these individuals will generally receive subprime rates, because they represent a great deal of risk due to their being ‘unknown’.

    Score: 300-619

    Rating: Bad Credit

    Description: This is the lowest credit rating possible, and represents an individual that consistently demonstrates a great deal of lending risk. These individuals are not generally even given funds without full security, and even then they come with an extremely high interest rate. In general, as we get down to this level, we start to see credit arbitration and bankruptcy become involved.

    Types of Credit Available: Cash secured credit cards with high rates are an option, as do other highly-secured products meant to rebuild credit ratings. However, these sorts of borrowers will still receive high interest amounts of those secured loans, because they still represent a risk to the lender, despite the high level of security.

    Score: 620-659

    Rating: Sub-Prime

    Description: A sub-prime loan is usually extended to an individual that is generally inexperienced with different kinds of debt, or has demonstrated a casually risky behavior. These individuals represent risk in the way that they might become overwhelmed by payments, or might be exposed to negative shifts in their situation. In general, a borrower that has leveraged over 70% of an individual asset may automatically be given sub-prime status, because of the way in which fluctuating home values impact the integrity of the loan.

    Types of Credit Available: A sub-prime loan is usually extended, but at rates that are less favorable than they could be. Additional security may be required, or an individual may be required to make a more aggressive repayment plan with the lender to ensure the safety of the debt.

    Score: 660-720

    Rating: Prime

    Description: A prime loan represents one that is considered to be ‘fair’, or of very little risk. An individual with a rating of prime demonstrates a reasonable propensity for paying off debt, and a somewhat diverse range of experience with different types of products. These borrowers will be less restricted in the amount of collateral that they post, as well as the amount of down-payment that might be necessary.

    Types of Credit Available:

    Score:Prime borrowers are highly sought after by lenders because of their willingness to deal with debt. They reward them with a standard low interest rate that is known as the ‘prime’ rate.

    Score: 721-751

    Rating: Prime Minus

    Description: A ‘minus’ score denotes an individual with a very strong history, and large breadth of experience with different types of loan products. The name refers to the way in which these individuals commonly qualify for interest rates that are below prime (ie. prime minus X%), and will generally require less security or supervision than even a prime loan.

    Types of Credit Available: A prime minus individual has access to all kinds of debt products, and will qualify for either the prime rate, or a rate that is slightly lower than the prime rate.

    Score: 751+

    Rating: Excellent Credit

    Description: An ‘excellent’ rating suggests that there is virtually no risk associated with lending to this individual, based on their history. These individuals are very established customers, and demonstrate an extremely rate amount of credit-worthiness.

    Types of Credit Available: An Excellent rating gives a borrower access to all forms of debt at interest rates that are extremely favorable. These loans are generally well below the prime rate, and can be minimally secured.

  • How is FICO Score Calculated?
  • There are four main factors that create a FICO score, each of which weighted towards their statistical relevance for predicting solvency. They are as follows:

    Payment history (35%)

    The applicant’s history for paying off obligations has the greatest impact on their FICO score. Essentially, if an individual displays a tendency for paying off their debt, they will likely continue to do so. However, if they’ve shown a willingness to miss payments, they will have that same risk going forward. This section may also include aspects such as bounced cheques (NSFs), or situations where a single obligation was created and unfulfilled.

    In general, the payments within this section are measured in accordance to the magnitude of the payment (the size of the obligation), and the quantity that are made in total. This means that a small bi-weekly payment has approximately as much ability to build up credit as does a larger monthly payment.
     
    Debt (30%)

    One of the biggest catch-22’s of the FICO score is the way in which having access to additional funds and credit improve the score. Essentially, the more lines of credit (ie. revolving loans) that an individual has access to, the better their FICO score will be. However, in order to access these types of debt in the first place, the applicant must have a decent credit score already.

    This makes the access to credit aspect of the FICO score a re-enforcing agent. Having a better credit score to begin with, combined with a willingness to take advantage of that credit score, combined with some discretion on the part of the applicant to keep those funds available for access, results in an even better FICO score over the long term.
     
    The way in which FICO scores measure an individual’s access to credit as a factor is through the use of something called the Revolving Utilization ratio. Revolving Utilization measures the relationship between credit balances and available limits. The more that available credit outweighs the used balance on a proportionate basis, the better the score. However, this also means that closing down a debt account (such as cancelling a credit card or line of credit) actually decreases a person’s credit score.
     
    Time in File (15%)

    A small but relevant aspect of an individual’s FICO score is the age of their overall file. This is measured as the overall time for which an individual has been building or managing their credit. In this section, an older file is considered to be less risky, because it has been around for long enough to show the tendencies of the individual to handle their debt. Alternatively, an account that has not really been listed for a long period of time may be seen as unstable, and will therefore have a less favorable grade.
     
    Account Diversity (10%)

    Another aspect of the FICO score that re-enforces an existing good score, but punishes applicants with poor scores, surrounds the individual’s actual experience dealing with debt itself. By taking into consideration the different kinds of credit products that an individual has used in the past, the FICO score considers an individual that is more experienced with different kinds of debt to be better able to handle future loans.

    For example, if an individual has had a credit card in the past, they are better able to manage a new card in the future because they know what to expect. The same thing goes for mortgages and lines of credit. What’s more is that an individual with experience dealing in a variety of types of debt is considered to be better able to handle a new product than an individual that has no experience with debt.

    Recent Searches for Credit (10%)

    The last aspect of the FICO score relates to whether or not an applicant is actively ‘credit seeking’. Every time an individual applies for a credit product, a small record is made on the account because it indicates that the individual is in the process of searching for additional credit. The fact that an individual is credit-seeking suggests that there may be some risks associated with the account that is requiring the applicant to seek out additional funds.

    What this essentially comes down to is that, the more you want credit, the less qualified you are to receive it. This means that the most credit-worthy individuals are those who already have access to it, and are content with their existing means of living. The trick is to therefore have ready access to credit before we actually need it.
     

  • What Negatively Impacts FICO Score?
  • While the above list of how the FICO score is composed provides an excellent broad reference of how a score is composed, it is important to understand how it is that specific actions impact our credit scores. For example, action such as missing payments, bouncing cheques, having payments submitted to collections companies, and have a court-order applied to an account can all have negative impacts on a FICO score.

    However, ‘soft-hits’ such as prescreening, yearly credit check-ups, credit counseling, and employment screening will generally have little-to-no effect on the score, because they are demonstrating an active search for credit. In general, we can see that inquiries will only have an impact on a FICO score if there is ‘permissible purpose’, meaning that the applicant has given an organization explicit permission to open up their credit file to examine their rating for a specific purpose, so as the procurement of a loan.