Credit Scoring

Introduction

Although it is usually the prospect of matching funds that brings people into AFI-funded IDA projects, with asset-specific training and support services playing a key role in keeping account holders on track, financial education can have an important and lasting effect on IDA project participants. In a 2003 survey by the Consumer Federation of America (CFA), only 2 percent of people said they knew their credit scores.¹ Only 3 percent of the people could name all three credit bureaus—the organizations that provide the information from which credit scores are derived. Even people who drop out of IDA projects before purchasing assets with their savings can benefit from the financial education they receive. IDA projects can have both immediate and long-term benefits by teaching participants the basic principles of budgeting, using financial services, and managing credit.

This article is designed to help AFI grantees understand and convey to IDA project participants the basics of credit scoring. AFI project staff will be able to help participants understand the reason credit scoring is used, who makes credit scores, how credit scores are derived, how credit scores are used, and practices for increasing credit scores. They often know they “have a number,” but they do not know how to get the number, what the number means, or how it is calculated.

What Is a Credit Score?

A credit score summarizes key pieces of a person’s credit history and is presented on his/her credit report as an overall number. The number is derived using a mathematical formula (or “model”) known only to the company that develops the credit score.

In general, credit scores are supposed to predict the likelihood that an individual will pay off his/her credit obligation as agreed. FICO (for the Fair Isaac Corporation) scores, for example, are specifically designed to “predict the likelihood that a borrower will default on any credit account within the next two years.”²

In most credit scoring models, a high number or credit score represents a low estimated risk to lenders. In other words, people with higher credit scores are supposed to be less likely to miss a loan payment than people with lower credit scores. Based on a scale that runs from 300 to 850, if a person has a FICO score of 600 or below, he/she has a 50 percent chance of being seriously delinquent in the next 2 years. By contrast, people with a FICO score greater than 701 have less than a 5 percent chance of being seriously delinquent.³ According to FICO, the median FICO score for the national population did not change between October 2008 and April 2009, and based on Equifax data alone, the national median FICO score remained 713.

The companies that produce credit scores use different credit scoring models. As a result, a person can have slightly different credit scores from different credit score producers. He/she might also have multiple scores from the same credit score producer. For example, FICO scores are based on information provided by the three main credit reporting agencies, and different information from these agencies can result in different FICO scores. The information provided by each of the reporting agencies is likely to be different because not all creditors report to all three agencies, and the agencies do not share information. Therefore, entire credit accounts may be missing from one credit report but present on the other two, for example. Although credit scores might vary for the individual, they will tend to be in a similar range.

In general, if lenders are looking at all three FICO scores (a credit score derived from each of the three credit reporting agencies), they will consider the middle score. But lenders might be looking at a completely different credit score or set of scores than the individual because there are so many.

In addition to the credit scores people generally know about, the credit scoring industry has specific products to serve defined target markets. For example, FICO and Equifax have developed a FICO Mortgage Industry Score that is supposed to be a 25 percent improvement for some markets on assessing mortgage repayment risk. This score will be available only to lenders in fall 2009. In addition, the new FICO Expansion Score is designed to predict credit risk for people who do not have enough credit history from which to generate traditional credit scores.

Credit score companies, as well as many in the financial services sector, generally assert that using credit scores makes credit more widely available and results in less discrimination. This is because credit scores derive from the same process for all consumers, regardless of age, sex, race, and ethnicity, or other individual characteristics that have historically been associated with discrimination in lending.

Who Makes Credit Scores?

Credit scores are primarily created by businesses that specialize in data and information management, by financial institutions, and by credit reporting agencies. Many companies make credit scores, but FICO is widely regarded as the dominant business in the credit scoring industry. In general, a person has three FICO scores based on the information provided by each of the three major credit reporting agencies—Equifax, Experian, and TransUnion. Each score is based on one of the credit history files the credit reporting agency maintains.

In addition to a FICO score based on data from the three credit reporting agencies, each of the agencies also offers its own credit scores. These are generally based on different ranges than the FICO score and can be purchased directly from the reporting agencies. For example, Experian sells the PLUS credit score and TransUnion sells the True Credit score. Neither the PLUS score nor True Credit score is connected in any way with FICO.

In 2006 the three major credit reporting agencies developed, through a joint venture, a new credit score to compete with FICO called the VantageScore. Whether lenders will abandon the long-used FICO score in favor of this new model is unclear for now. The differences between FICO and VantageScore are discussed further below.

Why Credit Scores Matter

If a person needs to borrow money, his/her credit score will likely determine whether he is approved for the credit and the rate he/she will pay to borrow the money. As such, a credit score provides access to credit and sets the price of the credit in tandem with the prime rate, which is based on the Federal Reserve funds rate.

The following example, based on the calculator on the myfico.com Web site, shows the impact that different credit score ranges can have on the cost of funds to a consumer. The table below is based on a $100,000, fixed, 30-year loan.

A person with a credit score of 670 would pay 42 percent more interest than a person with a 735 credit score, for example.

While the lending industry has historically been the biggest user of credit scoring, other industries have also started using credit scores as a shortcut to doing risk assessments and making decisions. For example, insurance agencies have other scoring models to assess customer risk, but also use credit scores to help paint the full risk assessment picture of a potential customer. In general, lower credit scores result in higher rates for coverage, and sometimes even denial of coverage.

Employers use credit scores as a proxy for trustworthiness, even in jobs that are not related to financial management. In some states, legislators are trying to outlaw the use of credit scores and credit reports as a screening mechanism for employment. Until they are successful, getting a job may be contingent on having a good credit score.

Like insurers and creditors, property owners are increasingly using credit scores to assess quickly the risks of renting to a particular individual or family. Bankruptcy (as reported on credit reports) used to be seen as the primary credit-related barrier to renting a place to live. Now, credit scores can also factor into the decision.

Finally, utility companies that require consumer deposits are using credit scores to help determine deposit levels for consumers. The lower the credit score, the higher the deposit because of the perceived risk that people with low scores are likely to be late or even miss payments.

About three-quarters of the adult population in the United States are believed to have credit scores.⁴ However, many people do not understand their scores or the impact they can have on their ability to get credit, insurance, employment, housing, and utilities. Given the potential for credit scoring to impact so many areas of a person’s life, it is important for people to understand what affects credit scores and what is affected by them. This knowledge can empower people to monitor their credit scores and take steps to improve them.

Credit Scoring and AFI Project Participants

Many people enrolled in AFI IDA projects are already concerned about their credit scores because they have heard they might have one and are not sure what it means. Generally, they have a vague notion about credit scoring and often know that qualifying for conventional credit is linked to this number.

IDA project participants with troubled credit histories often have low credit scores. This is primarily because the credit score is derived from information provided by credit reporting agencies on consumer credit reports. By giving participants information about how their bill-paying practices affect their credit scores, IDA project staff can empower participants to begin to improve their reported credit histories and credit scores.

Improving their credit scores is very important for project participants saving for a home purchase or small business development. Their credit scores can determine whether they will qualify for loans and loan terms. AFI projects provide a unique opportunity to affect participants’ credit scores in three distinct ways:

1. AFI projects provide financial education, including credit education.

2. AFI participants must save and participate in the program for at least 6 months. Most participants save for longer than the legislatively defined minimum. Therefore, the AFI project provides participants time to actually make changes to improve their credit scores based on the knowledge and skills gained in the financial education courses.

3. AFI projects often provide participants with ongoing one-on-one support. Participants potentially have someone monitoring their progress not only toward saving for their intended asset investments, but also toward improving their credit histories and scores.

Some AFI project administrators use credit scores as an indicator of improvement in participants’ economic conditions. At enrollment, project staff collect a person’s credit score, which provides the baseline score against which to measure improvement. Then on some predetermined schedule, staff obtain his/her credit score again from the same company that provided the baseline score. Comparing to baseline scores, staff can measure changes in scores that occur as participants complete their financial education and prepare for their asset purchases. Because there are so many credit scores, AFI program staff must select one credit score to use for the baseline and subsequent comparisons.

What Is Included in Credit Scores?

The simple answer to what is in a credit score is “it depends on the credit score.” Each business that generates credit scores uses its own set of information, and one business may have information that another does not have. This is why it is so important for AFI project staff to obtain credit scores from the same agency if they are planning to use the scores to assess changes in their participants’ economic circumstances.

In general, most credit scoring models take into account a person’s:

• Credit repayment history
• Balances on credit
• Rate at which they are using credit versus the amount of credit they have available
• Depth of credit history
• Length of credit history

However, different models assign different weights to certain types of information. This section compares FICO scores to VantageScore.

FICO

FICO scores are currently the most widely used by lenders. FICO scores range from 300 to 850, with the higher scores seen as more positive. The scores use five data categories to generate a person’s score. The five categories include:⁵

• Payment history, which shows a person’s track record in paying back debt. This data category accounts for 35 percent of the FICO score and is based on the following questions:
  • Has the person paid his/her obligations on time?
  • How often does the person pay late?
  • How late is the person?
  • How much has he/she been delinquent in the past?

Late payments, especially habitually late payments, indicate a higher level of risk in the scoring model.

• Amounts owed, which includes the debt a person currently owes and how much available credit he/she is using (also called the credit utilization rate). This data category accounts for 30 percent of the FICO score and is based on the following questions:
  • On all of a person’s credit sources, how much debt is he/she carrying?
  • What is the person’s credit utilization rate? How much credit is he/she using in relation to the credit limit?

High credit utilization rates are associated with higher levels of risk for lenders because they mean the person has tapped all or a greater percentage of his/her available credit.  

• Length of credit history, which is the length of time for which a person has had credit. This data category accounts for 15 percent of the FICO score and is based on the question:
  • How long has a person had credit?

The longer the credit history, the more information the model has from which to derive a score.

• New credit, which is used to determine whether a person has recently opened credit to catch up or cover budget shortfalls. This data category accounts for 10 percent of the score and is based on the following questions:
  • Has the person opened any new credit lines recently?
  • What kind and for how much?
  • Has the person been trying to get more credit (as indicated by inquiries)?

Repeated attempts to open new accounts may signal that a person is becoming over-extended.

• Types of credit used, which shows whether a person can handle diverse types of credit successfully. This data category accounts for 10 percent of the score and answers the following questions:
  • How many credit or department store charge cards does the person have?
  • How many auto loans?
  • Does he/she have any mortgages or student loans?
  • Can he/she manage multiple types of credit?

 The chart below shows the weight given to each of these factors in determining the overall FICO score.

VantageScore

Developed as a joint venture among the three major credit reporting agencies, VantageScore was launched in 2006. Rather than the 300–850 credit score range used by FICO, the VantageScore range is 501–990. Ranges within the VantageScore range are also assigned a letter grade A through F.

The VantageScore is based on six data categories:

• Payment History: Repayment behavior
• Utilization: Percentage of credit amount used and owed on accounts
• Balances: Amount of recently reported balances (current and delinquent)
• Depth of Credit: Length of credit history and types of credit
• Recent Credit: Number of recently opened credit accounts and credit inquiries
• Available Credit: Amount of credit available

The chart below shows the weight given to each of these factors in determining the score. At this point, it is unclear how widely used the VantageScore will become.

What Is Not Included in Credit Scores?

While there are many pieces of data about a person that go into calculating his/her credit score, some things cannot be included. The Equal Credit Opportunity Act prohibits the following items from being used in determining a person’s credit score:

• Race
• Color
• Religion
• National origin
• Sex
• Marital status⁶
• Receipt of public assistance
• Whether the person has “exercised any consumer right under the Consumer Credit Protection Act”

In addition, FICO specifically does not include a person’s age, salary, occupation, title or employer, employment history, or place of residence. FICO does not consider interest rates being charged on credit accounts, child or family support obligations or rental agreements, or whether the person is participating in credit counseling.

FICO also does not count certain inquiries against a person’s credit, including:

• Inquiries made by the consumer to check his/her credit report
• Inquiries made by lenders and other businesses to make pre-approved credit offers
• Inquiries that are considered administrative⁷

In general, FICO does not use any information that is not found on a credit report produced by one of the three major credit bureaus. Other credit scoring models may consider some of these factors even though FICO does not.

How Consumer Actions Impact Credit Scores

Credit scores are not static: They change regularly because consumer actions change regularly.

Many consumer actions impact credit scores. As outlined above, increasing credit utilization rates and not paying bills as agreed can cause credit scores to drop.

Closing credit accounts can also cause scores to drop for two reasons. First, if participants close their oldest accounts that have been inactive (e.g., a credit card opened at 18 years of age but not used much in the last 10 years), this shortens the length of credit history, which may cause a drop in credit scores. Second, closing accounts that have unused balances can cause the overall credit utilization rate to increase.

When consumers generate inquiries to their credit reports because they are shopping for credit, this may cause a drop in the scores. However, if someone is rate shopping for a particular kind of credit—looking for a car loan or shopping for a mortgage—all inquiries generated by the consumer within a 30-day period in a particular credit category are counted as one inquiry and will not adversely affect the credit score. This is a change in credit scoring models brought about by innovations in financial services that made rate shopping easy for consumers.⁸ Inquiries generated by a consumer for credit cards, department store cards, and other forms of revolving credit will likely negatively impact the credit score for each occurrence.

The following example developed by CFA and FICO and presented on a Federal Citizen Information Center (FCIC) factsheet shows the impact of specific consumer actions on a credit score over 2½ years.

The Role of Credit Reports in Credit Scoring

For FICO and VantageScore credit scores, the information used to develop scores comes from credit reports. In fact, FICO specifically states that all the information it uses to derive consumer credit scores comes from the credit reports generated by Equifax, TransUnion, or Experian.

Therefore, one of the most important issues for addressing credit scores is ensuring the credit reports from which they are generated are in fact accurate. An estimated 79 percent of all credit reports may contain some kind of error, and 25 percent contain errors that actually result in denial of credit.⁹

Getting and reviewing all three credit reports with AFI participants is the first step in improving their credit scores. This is covered in detail in the next section.

Strategies for Helping Participants Improve Their Credit Scores

Because so many decisions are based on credit scores, AFI participants will want to know what they can do to improve their own scores. Unfortunately, no easy answers or quick fixes exist in most cases. The following section provides several strategies for credit score improvement.¹⁰

The first step involves getting information. Participants should get their credit reports from all three credit reporting agencies and review them for accuracy.  Participants should be encouraged to get their annual free credit reports (one from each of the three major credit reporting agencies) as established by FACTA. Three options are available for doing this: accessing a Web site, making a phone call, or making a request via mail.

Many people find that requesting the report via the mail-in form is less cumbersome. However, accessing the reports via the Web site will result in immediate access to the information.

If errors are found, participants should submit letters of dispute to correct them directly to the credit reporting agencies. Each credit reporting agency has an online process for submitting letters of dispute.  Encourage participants to print copies of anything they submit electronically for their records. They can also call each credit reporting agency or write to them directly using the following information.

Second, AFI participants should be encouraged to get their FICO scores. FICO scores are available at www.myfico.com. Consumers can get their Equifax FICO score or TransUnion FICO score for $15.95 each. The Experian FICO score is no longer sold directly to consumers. Credit scores can also be ordered directly from credit bureaus. Those sold directly from the credit bureaus may not be FICO scores. For more information on ordering credit scores, see the appendix at the end of this article.

Third, participants should be assisted in setting up systems to pay all bills on time. Paying all bills as agreed will have the biggest impact on their credit scores, as 35 percent of the FICO score is comprised of their bill-paying track record. In terms of credit score, this is more important than dealing with an account in collections. Getting current if payments have been missed, and staying current with accounts, is key to improving and maintaining higher credit scores.

The fourth step is for participants to focus on paying down debt balances. This has to do with getting the amount of total outstanding debt lower and getting credit utilization rates into a range that does not negatively impact credit scores. Historically, consumers were told to keep their credit utilization rates around 50 percent. Most experts now agree that 20 percent is a better target to prevent negative impacts on credit scores.

This issue has been complicated during the economic crisis. FICO estimated that at least 30 million Americans had their credit limits arbitrarily reduced during the second half of 2008.¹¹ In many cases, credit utilization rates literally changed overnight for customers even though there was no change in their behaviors. The decrease in credit limits for consumers is a result of financial institutions’ desire to limit their risk during the recession.

Following is an example based on a hypothetical consumer, David. As shown in the table below, David’s credit utilization rate increased from 22 percent to 53 percent as a result of the adjustment to credit limits, even though there was no change in his behavior. The increase in credit utilization could ultimately lead to a decline in David’s credit score and increase in the cost of any credit he seeks in the future.

For credit scoring purposes only, consumers should pay down debt where the credit utilization rate is highest first, even if the interest rate on that debt is not the highest among the debts owed. This goes against conventional advice given to customers about paying down debt. Some financial advisers recommend paying down the debt with the highest interest rate first. This obviously saves the consumer money. If the consumer is not likely to need to use his credit score within the next 1–2 years, getting rid of the most costly debt still makes the most sense.

Generally, consumers should keep credit accounts open even if they do not use them or carry balances on them. This impacts both length of credit history and credit utilization rate. Before dispensing this advice to participants, however, AFI staff need to be sure they understand and convey the risks of having unused available credit. For participants who have had a very challenging time with credit, it may be better to take a hit on their credit scores as opposed to having the opportunity to easily accumulate another mountain of debt.

For the same reasons, participants should generally be advised against opening credit cards just to increase their available credit. In the end, this strategy could create more problems for participants and cause their credit scores to decline.

Conclusion

Credit scoring is an important topic in financial education because credit scores can affect so many aspects of a person’s life, including the ability to obtain credit, insurance, employment, and housing. IDA participants are often concerned about their credit scores because they may have poor credit histories and/or be planning to obtain loans to buy houses or start businesses. Credit scoring is complicated because of the number of credit reporting agencies and number of companies that produce credit scores. People likely have different credit scores produced by different credit scoring models, such as the one used by FICO. A person might also have more than one FICO score based on discrepancies in his/her credit reports from the three major reporting agencies.

AFI project staff must be able to explain this complex topic so that IDA participants understand what their credit scores mean and what is behind them. Participants also need to understand the areas of their lives that can be affected by low credit scores, as well as how their behavior can affect their scores. De-mystifying credit scores for IDA participants can empower them to monitor their scores and take steps to improve them, including correcting errors on their credit reports and taking advantage of the tools provided through financial education to help them pay their bills on time and pay down their debt consistent with their short- and long-term financial goals.

References

1. Avery, Robert B., Calem, Paul S. and Canner, Glenn B. Federal Reserve Board Division of Research and Statistics. Credit Report Accuracy and Access to Credit. Summer 2004. Federal Reserve Bulletin.

2. Consumer Federation of American and Fair Isaac Corporation. Your Credit Scores. Federal Citizen Information Center. http://www.pueblo.gsa.gov/cic_text/money/creditscores/your.htm

3. Consumer’s Union. 2009. Credit scores: Which ones do lenders use? ConsumerReports.org 

4. Giuffrida, Inger. 2006. Delivering Effective and Engaging Financial Education: A Training for Facilitators. Assets Alliance.

5. Giuffrida, Inger. 2008. Financial Health Increases Your Wealth. Developed for Citizen Potawatomi Nation.

6. Leondis, Alexis. July 5, 2009. FICO Scores Show Flaws as U.S. Banks Cut Credit Lines. Bloomberg.com.

7. Wozniacka, Malgorzala and Sen, Snigdha. November 23, 2004. Credit Scores – What You Should Know About Your Own. Frontline/WGBH.

8. Ziegler, Suzanne. June 14, 2009. Hard times make credit score key. Minneapolis-St. Paul Star Tribune.

9. Study: How Credit Line Decreases Can Affect FICO Scores. 2009. Fair Isaac Corporation Web site. www.fico.com.

10. www.myfico.com