Credit Scoring

We are all aware of the importance of good credit. A good credit rating is the key to financial freedom. What is not known is what makes a credit rating good, or how good does it need to be? This is what we are going to address. 

Every time you use credit or apply for credit, the credit bureaus are notified. There are 3 credit bureaus (Equifax, Experian and Trans Union). Most creditors report to all three bureaus but some don’t. This is why when you apply for a mortgage all 3 bureaus are contacted. You should also keep in mind that it can take of up to 90 days from the time you use your credit, or pay down your outstanding balance, to the time it is actually reported to the bureaus.

Reviewing credit reports has always been very subjective. Each individual underwriter draws off his or her own experience in deciding the creditworthiness of an applicant. Each lender develops its own set of standards for mortgage products for their underwriters to work with. This combination leads to a certain amount of inconsistency in deciding the creditworthiness of applicants with similar credit profiles.

Fair, Isaac Company, based in California, attacked this problem in the late 1980’s. They studied millions of credit files, looking for patterns that could accurately predict potential default rates. Once these patterns were identified, a mathematical model was developed that was capable of predicting the probability of an applicant defaulting on a loan. The intention was to take the human element out of the decision process. The program that they wrote was then incorporated, with minor modifications, into each of the 3 bureaus. This enabled the bureaus to assign a credit score associated with an applicant. Equifax issues a Beacon Score, Experian a FICO Score and Trans Union an Empirica Score. Since the data reported to each bureau is slightly different, the scores will also be different. Most lenders will use the middle value in determining the score used to evaluate the applicant.

The actual formula for calculating a credit score is a trade secret and the statistical modeling that the formula is derived from is constantly being revised. There is, however, some general information that has become available over the years.

Your credit score is developed from a sampling of the data in your report. This means two things. First, having a longer credit report is better than having a short report. A late payment on one credit card when there are only 3 pieces of information on your report is going to have a greater impact that if you have 20 pieces of credit on your report. Second, reports run within weeks of each other, with no apparent differences in how credit has been utilized, can yield different scores. Different samplings of data can yield different scores.

Your “Score” is a number between 300 and 850. The higher the number, the better a credit risk you are.  A score below 680 is generally a cause for concern for a lender. Should the score fall below 620 it becomes a serious issue. An applicant at this level will be limited in the types of mortgage products available and will most likely pay a higher interest rate on his financing. Anything below 600 generally is too low for any type of credit. Because of all the research done on patterns of consumer defaults, the lending industry has been able to create a sliding scale of interest rates. Instead of simply approving or declining an application, a lender now has the ability to price a mortgage based on the probability of default. This is called “risked based pricing”. This has made credit available to a wider range of applicants than ever before.

A loan is considered delinquent if the borrower has fallen behind on his payments for 90 days or greater. An applicant with a score below 600 has a 1 in 8 chance that he will become delinquent in at least one of his outstanding loans. As the score moves to 659 the odds fall to a 1 in 26 chance, from 660 to 679 it drops to 1 in 38, from 680 to 699 it's 1 in 55, from 700 to 719 it's at 1 in 123, from 720 to 759 it's at 1 in 323, from 760 to 799 it's at 1 in 597 and at 800 and above it falls to a 1 in 1,292 chance. These odds are only approximate and they are constantly being revised. Loans age and the economic conditions of the country change over time. New data is constantly being added to the computer model to reflect these changes.

The credit score is based on approximately 45 different criteria from your credit profile. The most important component is how you currently pay your bills. This represents approximately 35% of your score. Your most recent history carries the most weight here. Recent minor late payments can easily have a greater impact than severe credit problems in the past. For example, the common assumption that you need to wait 7 years after a bankruptcy before you can be considered for a mortgage is simply not true. The discharge need only be 2 years ago as long as you have properly re-established credit. You will pay no higher an interest rate than if the bankruptcy never occurred.

The second most important component is your credit utilization. How you utilize your existing credit impacts roughly 30% of your score. The closer you are to your credit limits on your credit cards, credit lines, etc, the greater the chances you have of having financial difficulties. Knowing this, you are in a stronger financial position to distribute your debt over several cards, instead of focusing on one credit card with a high balance. 

Many people are afraid to have too many credit cards. They feel that having the credit available is too large a temptation. They will maintain only one card and keep a balance on it. The only danger in this approach is that should there be any minor problems in paying the monthly payment, it ends up having a larger than necessary impact on your credit score. A safer approach would be to have several cards, even if you only use one regularly. The more data available for your score to be based on, the more representative the score will be of the way you use your credit.

The longer the credit history you have, the better. This can impact your score by as much as 15%. Short credit histories can mean one of two things. You may simply have had no need, or want, for credit or you simply couldn’t get credit. There is no way to distinguish between these two totally different conditions. It is in your best interests to start developing a positive credit history as soon as you can. You never know when you are going to want, or need, credit in the future.

Every time you apply for credit an inquiry appears on your report. Too many inquiries can negatively impact your score. This is a misunderstood component of your score. First, the number of inquiries only contributes 10% to your score, so it’s not in itself a major component. Second, credit inquiries from non-credit issuing entities aren’t counted. So, if your insurance agent runs your credit report or your landlord does, there is no impact on your score. 

If you’re shopping for a car and every dealer you talk with runs a credit report, this is counted as one inquiry. Inquiries for consumer debt dated within a 14 day period are considered one inquiry and inquiries for a mortgage within a 45 day period are considered one inquiry.

There is a common misconception that there are numerous errors on your credit report. Over the 20 years that I’ve been in this business, I’ve reviewed thousands of credit reports finding but a handful of mistakes.  Anytime we find derogatory items on a credit report we discuss them with the applicant. Items that the applicant thinks, at first look, as being erroneous usually turn out to be correct after a closer investigation.

For instance, the applicant didn’t realize that the payment history of the car loan he co-signed for would appear on his credit report. This quite often is the first time the applicant sees the detailed payment history. All correspondences regarding this loan would routinely be mailed to the primary borrower. It’s not until the loan is delinquent, that the lender will contact the co-borrower. 

A mysterious lender appears on the report. Upon further investigation it turns out to be a different name for a bank that the applicant was already using. Another common occurrence would be the result of one institution acquiring another. The applicant may not immediately recognize the new lender as the same lender he has been dealing with for years.

A collection account appears on the report. It turns out to be from an old medical bill that was long forgotten. Doctors and hospitals will turn over outstanding bills to a collection agency if your insurance company, or you, don’t pay them quickly enough. The collection agency may or may not follow up with you, but they will immediately report the collection account to the credit bureaus. 

They know full well that you will be applying for some form of credit in the future. Their collection account will appear and you will then contact them to correct the matter. It is only a matter of time.

Do you think that doubling up on the minimum payment on this month’s Visa bill will release you of the responsibility of making the required payment next month? Unfortunately, unless the creditor is specifically instructed to do otherwise, the additional payment will be used to pay down the outstanding balance. Not making next month’s payment will result with a 30-day late notation on the account in addition to you now being obligated to pay the late charge on the account.

Do errors happen? Yes. The typical errors are due to the blending of credit data on similar named people living at the same address. A father giving his name to his son will inevitably cause the credit data to blend. Bear in mind this is only a real concern when one has good credit and the other bad. If both have good credit, even this error is meaningless. 

Another typical example is when someone steals your credit card, or all your cards, and starts charging to your account. This is not as serious as it seems. Once you’ve notified the creditors as to what has happened, they will immediately alert the credit bureaus, and your file will reflect the theft.

The errors that you need to be pro-active with are situations when the creditor neglects to update your file. This is common when you pay off a collection account or a judgment. Once the creditor gets his money, he has no incentive to correct your records. You need to be sure that you get confirmation, in writing, that your bill was satisfied. Keep that along with a copy of your cancelled check and any other correspondences regarding the matter. Should the creditor not report that the account was paid to the bureaus, you will have all the necessary paperwork to prove otherwise. Your documents will supercede the data in your credit file. 

It’s easy to keep your credit report accurate. If you have a product dispute with a store, do as much as you can in writing and keep copies of everything. If you have a problem with your insurance company paying a medical bill, stay on top of the problem and follow it through to the end, keeping copies of everything. 

If you are contacted by a collection agency in error, have them confirm it to you in writing. If you are turned down for credit, you are entitled to receive a free copy of your credit report. Ask for it and review it, you may find out they received a report on the wrong person or you may have errors that need to be corrected. Supplying copies of the documents you kept to this creditor will prove that you are entitled to the credit for which you applied.

You can routinely monitor your credit report for free. Each credit repository is required by law to supply you with a copy of your report on an annual basis for no cost. All you have to do is ask. Www.annualcreditreport.com is a site that is provided free to the public. The best way to utilize this site is to visit it 3 times a year, each time requesting you report from one of the repositories. Each repository is required to give you a copy of your report annually for no charge. By staggering your requests over the year you see your report every 4 months. This gives you the ability to address any issues on your report before they present a problem. 

Errors in a credit report are not as common as most think. A study was recently done and the results were published in the May 23, 2011 National Mortgage News in an article written by Brad Finkelstein.

Here’s what was reported:

Fixing an error in one’s credit report could be beneficial to that person getting a loan but a study finds that very few disputes resolved lead to an increase in the credit score of 25 points or greater.

The study involved over 2,300 consumers who reviewed nearly 3,900 credit bureau files (some only looked at one bureau’s file, others had access to three). The Policy and Economic Research Council conducted it using a grant from the Consumer Data Industry Association.

“We found that a vast majority of credit reports are accurate and that it is rare for a credit report error to materially impact a consumer’s access to credit and the terms of that credit. The facts are that credit report errors are relatively infrequent, and that errors that negatively impact creditworthiness are significantly lower than one may suspect.” said Michael Turner, president and CEO of PERC, in a press release.

Nearly 81% of the files reviewed had no identified items which were potential disputes. Approximately two-thirds of those who had one or more items to dispute did contact the credit reporting agency involved, with 19% not planning to dispute and the remainder planning to dispute but did not complete the process in time to be included.

The study noted that nearly one-quarter of the consumers in each of the lower Vantage Score bands of between 501 and 599 and 600 and 699 were likely to dispute an error, with 19% in the 700 to 799 range, 14% in the 800 to 899 range and 17% in the 900 to 999 range likely to dispute an error. The study used VantageScore scores because of the consistency of the scores across the three bureaus.

Regarding the type of potential disputes, 63% involved “material” information such as credit, collection or public record data; while 37% was over “nonmaterial” data such as the file header.

Of the files involved, 210 had trade line disputes, covering 435 trade lines. The disputes resulted in 45% having the trade line information modified and 41% had it deleted. Approximately 40% of the modifications resulted in a higher score and 16% in a lower one. The authors pointed out those who believed a modification would hurt their score were not likely to pursue it.

Of the 286 files that were modified, only 36 or 0.93% of the entire sample saw an increase in their credit scores of 25 basis points or greater. However, the report notes, the size of the increase may not be relevant on whether it moves the consumer up into the next tier. “For one person, a three-point increase could result in better credit terms while a 43-point increase for another may not.”

So after the disputed process had run its course, the study found that just 0.50% of the sample had moved up to a higher “credit risk tier.”