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Did you know: The Basics of Credit Scoring

Date: September 15, 2020

By John Ulzheimer

In the current economic climate, it can be helpful to take a “Credit Score 101” course to keep us refreshed on the fundamentals of credit scoring, so we don’t fall behind on basic credit knowledge and maintenance. So let’s start from the very beginning…

Credit scores are commonly used by lenders as part of their risk assessment and underwriting processes. In fact, credit scores have been used as part of the financial services environment for decades. Simply put, consumers who have better scores are going to get better deals on loan and other forms of credit. Because they are so important, it’s important that you know what counts in your credit scores, and how much?

Credit Reports

Credit scoring models are called credit scoring models for a reason. These scores are generally based on the information in your credit reports as maintained by the three national credit reporting companies (CRCs); Equifax, Experian and TransUnion. The better your credit reports, the better your credit scores.

Conversely, information that is not on your credit reports does not have any influence over your credit scores. This includes your income, savings and other deposit accounts, debit cards, level of education and your political affiliation. And, there are even items that are on your credit reports that are not considered. This includes your address, employment, age, and Social Security Number.

What Counts, and How Much?

Generally speaking, there are five categories of information considered by credit scoring systems:

1. Your Payment History: This category can also be referred to as the “presence or lack of negative information.” This category is highly influential and accounts for about 1/3rd of the points in your credit scores.

If you have late payments, defaults, collection accounts, repossessions, bankruptcies, tax liens, judgments, foreclosures, settlements, or anything else that indicates negative loan performance, you will forgo points from this category.

One thing to keep in mind as you’re considering this information is that many of of the points in your credit scores have nothing to do with you making all of your payments on time. So while it’s always a best practice to make your payments in a timely manner, it won’t guarantee that you have an elite credit score.

NOTE: Currently the credit reporting companies are not collecting or maintaining tax liens or civil judgments. If they are eventually re-reported they will again be considered as negative credit entries.

2. Your Debt: This category is also highly influential on the points in your credit scores. There are three types of debt that are considered by credit scoring systems. They are: revolving debt (like your credit cards), installment debt (like your auto loan), and open debt (like collections and charge cards).

Having debt is not inherently bad. For example, if you have several hundred thousand dollars of mortgage debt it’s still very easy to earn elite credit scores. But, if you have too much credit card debt that can be quite damaging, especially if your credit card balances represent too much of your credit limits. Maintaining low or no balances on your credit cards is a great way to capture many of the points in this debt category.

3. The Age of your Credit Reports, Inquiries, and Account Experience: These last three categories collectively account for the remaining points in your credit scores. None of them, individually, is highly influential to your credit scores but collectively, they are worth as much as the debt and payment history related metrics. Point being, if you want to earn and maintain elite credit scores, you have to do well in all of these categories.

Age: This metric has nothing to do with your age or date of birth. Instead, it has everything to do with the age of your credit reports. Credit scores can determine the age of your credit reports by calculating the average age of your accounts and also by considering the age of your oldest account. Older is always better for your scores.

Inquiries: When you apply for credit and a lender pulls your credit report, a record of that “pull” is placed on your credit report. This is what’s called a “credit inquiry.” Not all inquiries impact your score, but some do. Keep in mind that inquiries are the least important aspect of your credit scores and are only considered while they are less than 12 months old.

Account Experience: There are many different types of extensions of credit. Credit cards, charge cards, mortgage loans, auto loans, student loans, personal loans are several examples. Consumers who have experience managing different types of credit obligations will earn more points in this category than consumers who have very limited credit experience.

Summary

All of the commonly used credit scoring models have a score range of 300 on the low end to 850 on the high end. You want to score higher rather than lower. The higher you score, the less risk you pose to lenders. As such, lenders will likely offer more competitive terms.

In order to earn and maintain really high scores, like those at or above 800, then you’ll have to perform well in each of the above categories. You can do that by making all of your payments on time, maintaining low credit card balances, and applying for credit sparingly.

The views and opinions expressed in this article are those of the author (credit expert John Ulzheimer) and not necessarily those of VantageScore Solutions, LLC.