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Credit scoring factors in your income and education as well as your credit history. You may never know your score, but you should know if you’re seen as a risk.
By Mary Rowland
Remember the old Jimmy Stewart movie, “It's a Wonderful Life”? It's Christmastime in early 1940s small town America. Stewart plays a banker at a savings and loan who has loaned money to the poor to help them build decent homes. Now he faces ruin at the hands of a heartless Lionel Barrymore, who has found a misplaced bank deposit, called in the auditors and started a run on Stewart's bank. But the "little people" who Stewart put his faith in prove him right. They stream in with their dimes and quarters and dollars to bail him out.
Fast-forward half a century. A computer has replaced Jimmy Stewart. Whether you get a loan to buy a home depends on a computer-generated credit score that compares certain things about you. Things like how much money you earn, how long you've been using credit and whether you've made payments on time determine your credit worthiness.
"The lender wants to know, ‘If I lend money to 100 or 1,000 or 10,000 borrowers with these characteristics, will 90% or 95% or 99% repay?’" says Peter L. McCorkell, senior vice president at Fair Isaac, the leader in developing these scoring systems for lenders. You will be able to know
For years, the entire credit scoring process was shrouded in mystery. Fair Isaac and other scoring firms said that if they revealed the scoring system -- and the exact criteria to determine that score -- their services wouldn’t be needed anymore.
In June 2000, Fair, Isaac surrendered to increasing pressure from Congress and consumer groups and released a list of the criteria it uses to determine credit scores. In addition, the company plans to develop a web feature so you can check your own score.
The five main criteria are:
- Your payment history payment history on credit cards, retail accounts at stores, installment loans, and mortgages. 35% of total score
- Amounts owed. What is important is how many accounts have balances and how much of the total credit line is being used on credit cards and other "revolving credit" accounts. 30% of total score.
- Length of credit history. That’s why parents should help children establish credit histories before they go out on their own. 15% of total score.
- New credit. Applying for too much new credit is one of the easiest ways for people to inadvertently harm their credit score. (10% of total score)
- Types of credit. This takes into account your mix of installment loans, mortgages, retail accounts, credit cards and finance company accounts. (10% of total score)
The scores that companies like Fair, Isaac compile are sent to the credit reporting agencies as composite numbers. In addition to your salary and other factors mentioned above, here are some of the things that scoring agencies consider:
- Your education level. It sounds arbitrary, but it’s true. A college-educated person is given more “points” than a high school graduate, for example.
- The number of years you’ve lived in a single location. If you’ve moved around a lot, you lose precious points. If you’ve moved because of a better-paying job, you can recoup some of those points if your salary has increased, for example.
- The number of years you’ve worked for a single employer. Scoring agencies like people who are stable. That’s why they assign more points to people who’ve lived in a particular place for several years or who’ve worked for a single employer for many years.
- Are you a homeowner? If you are, you get additional points. Renters are considered more transient and less reliable to repay their loans.
If all of this sounds arbitrary or unfair, remember that scoring systems have allowed department stores and other lending agencies to offer those “on-the-spot” credit approvals. You know the routine. You fill out some basic information on a card and five minutes later (if the computer is working properly), you’re either approved or disapproved for a loan.
Credit scoring spurs growth
McCorkell argues that credit scoring has helped fuel the economic boom of the 1990s because it allowed those who grant credit to grant much more of it -- 20% to 30% more, by his estimates -- than they otherwise would have.
“Today more credit at lower rates is available to a broader spectrum of American consumers than anyone could have imagined just a generation ago,” he says.
Edward P. Howard, an attorney at the Center for Law in the Public Interest in Los Angeles, agrees that credit scoring has helped provide economic growth without inflation. But he worries about what can go wrong. There are a lot of elements stored in the computer.
“Even a fairly simple credit scoring system is likely to have 10,000 or 20,000 different possible combinations,” McCorkell says. That's a lot of information to keep straight. What if it gets scrambled up?
OK, Howard knows it isn't realistic to think that Jimmy Stewart is going to loan any of us the money to buy a home today. But he's worried about your financial viability -- your ability to borrow money, get a job, buy a home or rent an apartment. It all depends on a database that’s supposed to be fail-safe. Howard's favorite movie is "Dr. Strangelove," the Cold War satire in which a mad U.S. general finds a loophole that allows him to launch a nuclear strike against the Soviet Union. So back in the real world, could this one credit database have a flaw that could destroy your hopes of buying a new home?
You’re about to know more
Some things would seem obvious in credit scoring. A high income earns more points than a low income. But minorities get lower scores, too; a controversial issue that McCorkell insists does not lead to rejection of credit applications by minorities. "Minorities and low-income borrowers present a slightly larger risk," McCorkell says.
Fair, Isaac is only part of the process. Once the company processes a score, it is then transmitted to the lender, which makes the ultimate decision on whether a credit application is approved or denied. Lenders insist that the scoring system does not unfairly hurt minorities, but simply reflects overall lending histories.
When he was asked how an applicant can improve his or her credit score, McCorkell replied that you "shouldn't focus on credit scores, but on the responsible use of credit."
But, of course, we will try to improve our credit scores, won't we? There are certain things we do know. Fewer credit cards are better than several cards. Paying on time is a must.
In "The Ultimate Credit Handbook," Gerri Detweiler says, "The more you look like other people who pay their bills on time, the more likely it is the computer will approve your application."
Some of the things that weigh heavily are stability -- both at home and on the job -- and a good payment history.
The scoring system looks at how close you are to the limits on your cards, what you spend money on and how much you ask for in cash advances. Pay attention. But don't despair.
"Even if you are head over heels in debt,” Detweiler says, “you can rebuild your credit and improve your score."
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