Credit scores explained

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Credit scores explained
2 years ago
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Any time that you apply for any type of credit account, creditors want to know one thing and one thing only: When their company lends you money, will they be able to get it back from you in a timely manner and without any trouble?

This is where your credit score (referred to as a FICO score) enters the process. Rather than interview you, ask you for references, or administer lie detector tests about your intentions, creditors can get a simple answer to their questions about your trustworthiness by pulling your credit report and looking at a three digit number that lets lenders know what kind of account holder you are likely to be. This not only streamlines the credit application process so that it is fast and easy for creditors and consumers alike, but it prevents discrimination of any type because credit standards can be uniformly applied to all applicants using objective numbers rather than subjective opinions.

Whatever method used, the bottom line in the world of credit is that these days your score is synonymous with your character. As it has previously been said, lenders want to know that you will pay back what they have lent to you. For them, your credit score helps them judge whether or not you are likely to do that. They figure that how likely you are to repay them is based on how you have repaid others over the years. Are you the kind of person that can be trusted to honor the terms of the loan, or are you irresponsible with your finances and will likely pose a risk to their company?

In trying to figure these things out, it is important to realize that no person with any length of credit history has just one score that provides all of this information. Over the years, the process of credit scoring has become much more complicated. First, you must remember that there are three different national credit bureaus: Experian, TransUnion, and Equifax. The data in a consumer's credit file varies depending on the bureau because different creditors may report different occurrences and at different times, depending on company policy. Therefore, even if the credit bureaus used a uniform scoring model, credit scores from each of them can be different based solely on the information in a consumer's file. Unfortunately, the three national credit bureaus do not use the same scoring model, resulting in a (sometimes wide) disparity in FICO scores between them. This means, for example, that a consumer can technically qualify for credit with their Experian FICO score but miss the mark with their TransUnion and Equifax scores. See the problem here?

What has been even more confusing is that some companies have adopted their own scoring models, so that automotive lenders might look more closely at a consumer's past car loans while credit card companies might consider revolving credit card accounts more important in determining a consumer's credit score for lending purposes. In addition to the already mystifying process of determining FICO scores, these individualized company scoring models serve to further complicate what was meant to be an easy, streamlined process of determining a person's creditworthiness. Consumers began to long for a more reliable way to understand their credit score and their chances of being approved for a loan at an affordable interest rate, while creditors want one number that "says it all".

In an attempt to combat this problem, the three national credit bureaus announced in March 2006 that they were going to leave Fair Isaac?ôs FICO scoring system behind for a new type of score called VantageScore. This scoring model, the bureaus purported, would be uniform across the board so that any difference in scores would simply be due to the different information in the consumer's credit file - not to different scoring models. Instead of the 300 - 850 score range that FICO scores reported, consumers would be rated on a scale of 501 - 990, and would in addition receive a corresponding letter grade (e.g. A 990 score would translate into an "A" grade). Although Vantage Scores are still available to use, this scoring system never quite caught on, and most creditors still use FICO scores to determine creditworthiness.

As if there isn't enough disparity between current scoring models, the world of credit scores continues to evolve. Still anxious for a way to be more fair to consumers and help creditors better determine creditworthiness, FICO has introduced a new kind of score: FICO NextGen scores. FICO's website says that these scores offer better risk assessment, which will allow lenders to increase the approval rates for accounts by up to 5 percent, while lowering the number of "bad accounts" (people who do not repay) by between 10 and 25 percent. Supposedly, these scores will offer deeper credit analysis and evaluate subtle patterns in a consumer's credit behavior. This will allow for a more clear separation between those who have just had a little credit trouble and those who pose a serious risk.

For creditors, this means increasing their profits from opening new accounts and reducing their losses from avoiding non-paying consumers.

For consumers, the use of these scores could mean qualifying for better interest rates, or, in some cases, qualifying for credit at all. For all parties involved, a new scoring system like this certainly has the potential to bring some much-needed clarity to the confusing world of credit scoring.

by V. Johnson
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