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Credit Score - The FICO Score
From Wikipedia, the free encyclopedia.
A credit score is a number that represents an estimate of an individual's financial creditworthiness as calculated by a statistical model. A credit score attempts to quantify the likelihood that a prospective borrower will fail to repay a loan or other credit obligation satisfactorily. A credit score is based on a subset of the information in an individual's credit report. Lenders such as banks and credit card companies use credit scores to manage the risk posed by lending money to consumers. Examples of such uses include determining who qualifies for a loan, assigning an interest rate, assigning credit limits, and managing accounts that are already open (for example, treatment of accounts that are in default). The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system.
The FICO score
FICO , an acronym for Fair Isaac Corporation (traded publicly under the symbol FIC) often refers to the best-known credit score in the United States which is calculated using mathematical formulae developed by this company. This score is one of the most important factors in obtaining credit in the United States . For institutions that use scores as a factor in their lending decisions, scores below certain numbers (typically set by each lender's risk management department) may result in denial of credit, or credit being offered at a higher interest rate.
The three major credit reporting agencies in the United States , (Equifax, Experian and Trans Union) calculate their own versions of this score, which goes by different trademark names at each credit bureau: Beacon at Equifax; Empirica at Trans Union, and Fair Isaac Risk Score at Experian. These versions, while all developed for the agencies by Fair Isaac, are believed to differ slightly. Fair Isaac also offers multiple variations on their popular score, for example "Classic" FICO or "Next Gen" FICO.
It is worth mentioning that each of these credit reporting agencies also have developed their own separate proprietary versions of a credit score intended to compete with Fair Isaac's score. Although not the "gold standard", these scores (for example Trans Union 's "TransRisk" score or Experian's "ScoreX" score) are much less expensive than the FICO score; and often out-perform the FICO score at its intended purpose which is to determine the risk level of a prospective borrower. The cost savings of a non-FICO score are very tempting to banks and credit card companies who need an accurate risk assessment on millions of accounts every year. Only time will tell if these cheaper and possibly superior alternative scores will displace Fair Isaac from its dominant position in the U.S. market for credit scores.
Nearly all large banks also build and use their own proprietary statistical models for credit scoring purposes, often in conjunction with the FICO score or other outside scores.
The statistical models that generate credit scores are subject to federal regulations. The Federal Reserve Board's Regulation B, which implements the Equal Credit Opportunity Act, expressly prohibits a credit scoring model from considering any prohibited basis such as race, color, religion, national origin, sex, or marital status. Regulation B also stipulates that credit scoring models must be empirically derived and statistically sound. Furthermore, if an adverse action is taken as a result of the credit score (e.g. an individual's application for credit is denied) then specific reasons for the denial must be provided to the individual. A statement that the individual "failed to score high enough" is insufficient; the reasons must be specific.
There exist several generally accepted algorithms for extracting the primary contributing factors to a low credit score. One or more of these algorithms is typically used to supply a list of reasons when a loan applicant has been denied credit, in order to satisfy the Regulation B requirement that specific reasons are disclosed. Some consumers feel these adverse action reasons are somewhat disingenuous, as the only determining factor for credit denials is a numeric score -- the "reasons" are summed up only for the consumer.
As mentioned above, each credit bureau also has one or more of its own generic credit scores, available both to consumers on their websites and to lenders. For ease of use, these scores tend to be mathematically scaled so that they fall in the same general range as the FICO score. These scores are used by some businesses to assess creditworthiness (otherwise they would not be offered), however the FICO score remains the dominant score in use today.
Credit Scores available online
FICO scores are available online, on websites such as https://www.membershipme.com/ offers scores from all three bureaus. This is significantly more than potential creditors pay for the same information.
Makeup of the FICO score
FICO scores and its variants are designed to measure the risk of default, by taking into account various factors. Although the exact formula for calculating the FICO score is a closely guarded secret, Fair Isaac has disclosed the following components and the approximate weighted contribution of each:
35% punctuality of payment in the past
30% capacity used, i.e., ratio of current revolving debt (e.g. credit card balances) to total available revolving credit (e.g. credit limits)
15% length of credit history
10% types of credit used (installment, revolving, consumer finance)
10% recent search for credit and/or amount of credit obtained recently
The above percentages provide very limited guidance in understanding a credit score. For example, the 10% of the score allocated to "types of credit used" is undefined, leaving consumers unaware what type of credit mix to pursue. "Length of credit history" is also a murky concept; it consists of multiple factors, two being the oldest account open, the average length of time an account has been open.
Further, Fair Isaac does not use the same "scorecard" for everyone. The scorecards are segmented so that there are over 100 different actual scoring models that are applied to different individuals based on different ranges of input values (some scorecard segmentations include: age, depth of credit history, etc.). The implications of this segmentation are that while the approximate weighted contribution above may be an average across all scorecards, individuals will receive different scores or weightings based on the scorecard segmentation that they fall into.
Current income and employment history do not influence the FICO score, but they are also weighed when applying for credit. For instance, an unemployed individual will not usually be approved for a home mortgage, regardless of his or her FICO score.
There are other special factors which can weigh on the FICO score.
Any monies owed because of a court judgement, tax lien, or similar carry an extra negative penalty, especially when recent.
Having above a certain number of consumer finance company credit accounts also carries a negative weight (critics say that this causes a vicious cycle, locking people into continuing to use consumer finance companies).
The number of recent credit checks also can weigh down the score, although the credit agencies allow for credit checks made within a certain window of time to not aggregate, so as to allow the consumer to shop around.
Range of scores
FICO scores range from about 300 to 850 and exhibit a left-skewed distribution with a US median around 725. A score above 720 is considered to be "good credit," and a score below 600 is considered to be poor.
Free annual credit reports
As a result of the FACT Act (Fair and Accurate Credit Transactions Act), each U.S. resident is entitled to one free copy of their credit report from each credit reporting agency each year. For those with internet access, this information is available at the U.S. government-operated http://www.annualcreditreport.com . However, this report does not contain credit scores. Mostly useless consumer "credit scores", not used by any businesses, are offered for purchase at the time these reports are generated. Many other commercial websites offer free credit reports; usually these sites attempt to steer consumers to pay services.
Non-traditional uses of credit scores
In September 2004, a Texas utility company began setting individualized electricity prices based on credit score.
Recently, some of the agencies which generate credit scores have also been generating insurance scores, which insurance companies then use to rate the quality of potential customers.
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