Before credit scores we had real loan officers at the bank. Theirs jobs were to make loans and through instinct and experience determine the good loans from the bad loans.
Banks would keep score of their lending practices and reward those with good portfolio performance (lower default rates). Those loan officers with poor performance were demoted or let go.
Enter Fair Isaac and Company, they invented a computer model that could accurately calculate the default rate of each portfolio of loans that the lender loans out to people.
This revolutionized the banking/lending business and is partly if not wholly responsible for the viral expansion of lending companies.
Once banks could accurately predict success rates and default rates with a reasonable amount of certainty they could adjust interest rates within each group of credit scores to accurately cover the higher risks of loaning the money.
Meaning a group of borrowers with 640 FICO scores will pay higher rates than a group of borrowers with 720 FICO scores. The lower credit scores will statically produce higher default rates and the higher interest rates will compensate the lender for those extra losses.
Most People do not realize that a credit score is only an assignment of risk by the lender. They do not charge borrowers higher rates for more profit because they have lower scores, at least their not supposed to.
Subprime companies, companies that specialize in lower credit scores, have taken the lower FICO scored borrowers and gouged them for additional profits. They are paying the price for it now, as is the nation.
I digress, the credit scoring model is a moving target that moves with the economy to continue accurately predicting default rates. The FICO scoring engine has now been cloned by each credit repository. Each company has adopted their unique scoring Experian (Empirica Score), Equifax (Beacon Score) and Trans Union which still uses FICO.
All of the different scoring engines are still designed by Fair Isaac and Company to their specifications. Although each engine is tweaked differently below is a good representation of each model. Each of these percentages represent the "weight" given when determining a credit score.
- 35% - Payment
History - This simply is an average of how you have paid past creditors. As derogatory items age they weigh less and less, newer ones weigh heavier. This why when you pay off old debts to clean up your bureau your score actually drops. This is because the item update and is considered a fresh entry. Even though it shows a 0 balance it weighs heavier to the scoring model.
- 30% - Amounts
Owed - This is simply your credit-to-balance ratio. If you have $20,000 total credit available on your revolving accounts and have used $19,000 of it you are a higher credit risk. Likewise with your debt to income ratio, how much you earn verses how much you owe.
- 15% - Length
of Credit History - Length of credit is very important and often misunderstood by people with good payment histories and low FICO scores. I have seen people with great payment histories score as low as 640 on a bureau and people with a bump or two on their bureau score higher. The difference is length of time in the credit bureau.
The person with a bump or two may have a late payment or two but he has shown the ability to pay his debts over time. The person with a year or two in the bureau hasn't shown his true grit through the ups and downs of life.
- 10% - Types
of Credit - The bureau likes to see Installment debt, meaning the loan has a beginning and an end where the payments are steady i.e. car loans, mortgages. The bureau is less appreciative to revolving debt, credit cards, equity lines and other moving payment loans.
If your revolving debt is high (a lot of credit cards) the scoring model may see this as a potential for trouble in the future. This is why I advise my clients to close their credit cards when they pay them off and only leave a couple credit cards for length in the bureau.
- 10% - Inquiries (Applications for New Credit)- I am constantly confronted by borrowers by the question " if you pull my credit will it lowe my score"? The answer is a resounding, "I don't know". This scoring mechanism is ambiguous and in my opinion useless. I mean who isn't going to shop car loans and mortgages?
I think, I do not know, that the scoring model is looking for revolving debt. Recently, the three credit repositories were forced in court to change this scoring mechanism to exclude large ticket items like boats, cars and mortgages.
I have heard varying descriptions over the last ten year I have been in the mortgage business to the outline I just gave you. There are some discrepancies but from the most part they all follow this general outline. The truth is, the actually exact scoring model is a tightly guarded secret by Fair Isaac and company, for good reason.
If we knew what to do to trick the system it would be disastrous to their lively hood. After all their business is accurately predicting default rates.
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