Learn About Credit Scores

Ever wonder how a creditor decides whether to grant you credit?

For years, creditors have been using credit scoring systems to determine if you’d be a good risk for credit cards and auto loans. Credit scoring systems generally award points for each credit factor that helps predict who is most likely to repay a debt. More recently, credit scoring helps creditors evaluate your ability to repay home mortgage loans. Here’s how credit scoring works in helping decide who gets credit — and why.

  1. What is credit scoring?
  2. Why is it used?
  3. How is a credit scoring model developed?
  4. What can I do to improve my score?
  5. How reliable is the credit scoring system?
  6. What if I’m denied credit or don’t get the terms I want?


1. What is credit scoring?

Credit scoring is the system creditors use to help determine whether or not to give you credit.

Information about you and your credit experiences, such as your bill-paying history, the number and type of accounts you have, late payments, collection actions, outstanding debt, and the age of your accounts, is collected from your credit application and your credit report.

Using a statistical program, creditors compare this information to the credit performance of consumers with similar profiles.

A credit scoring system awards points for each factor that helps predict who is most likely to repay a debt. A total number of points — a credit score — helps predict how creditworthy you are, that is, how likely it is that you will repay a loan and make the payments when due.

Because your credit report is an important part of many credit scoring systems, it is very important to make sure it’s accurate before you submit a credit application.


2. Why is credit scoring used?

Creditors base credit scoring on real data and statistics, so it usually is more reliable than subjective or judgmental methods. It treats all applicants objectively.

Judgmental methods typically rely on criteria that are not systematically tested and can vary when applied by different individuals.


3. How is a credit scoring model developed?

To develop a model, a creditor selects a random sample of its customers, or a sample of similar customers if their sample is not large enough, and analyzes it statistically to identify characteristics that relate to creditworthiness.

Then, each of these factors is assigned a weight based on how strong a predictor it is of who would be a good credit risk. Each creditor may use its credit scoring model, different scoring models for different types of credit, or a generic model developed by a credit scoring company.

Under the Equal Credit Opportunity Act, a credit scoring system may not use certain characteristics like — race, sex, marital status, national origin, or religion — as factors. However, creditors are allowed to use age in properly designed scoring systems. But any scoring system that includes age must give equal treatment to elderly applicants.


4. What can I do to improve my score?

Credit scoring models are complex and often vary among creditors and for different types of credit. If any factor changes, your score may change — but improvement generally depends on how that factor relates to other factors considered by the model. Only creditors can explain your score under their particular model used to evaluate your credit application.

To improve your credit score under most models, concentrate on paying your bills on time, paying down outstanding balances, and not taking on new debt.

The following information generally applies to credit scoring models and are factors used to determine your score:

Have you paid your bills on time?

Payment history is typically a significant factor. Your score will likely be affected if items such as late payments, accounts referred to collections, and bankruptcy appears in your credit reports.

What is your outstanding debt?

Many scoring models evaluate the amount of debt you have compared to your credit limits. If the amount you owe is close to your credit limit, that is likely to hurt your score.

How long is your credit history?

Generally, models consider the length of your credit track record. Insufficient credit history may affect your score, but you can offset the negative by other factors, such as timely payments and low balances.

Have you applied for new credit recently?

Many scoring models consider whether you have applied for credit recently by looking at “inquiries” on your credit report when you apply for credit. If you have applied for too many new accounts recently, that may negatively affect your score. However, not all inquiries count. For example, inquiries by creditors who are monitoring your account or looking at credit reports to make “prescreened” credit offers do not count.

How many and what types of credit accounts do you have?

Although it is generally good to have established credit accounts, too many credit card accounts may hurt your score. Also, many models consider the type of credit accounts you have. For example, under some scoring models, loans from finance companies may negatively affect your credit score.

Some scoring models base scores on more than just information in your credit report.

For example, the model may consider information from your credit application as well: your job or occupation, length of employment, or whether you own a home.


5. How reliable is the credit scoring system?

Credit scoring systems enable creditors to evaluate millions of applicants consistently and impartially on many different characteristics. But to be statistically valid, credit scoring systems must be based on a big enough sample. Remember that these systems generally vary from creditor to creditor.

Although you may think such a system is arbitrary or impersonal, it can help make decisions faster, more accurately, and more impartially than individuals.

And many creditors design their systems to refer marginal cases (i.e., applicants whose scores are not high enough to pass easily or are low enough to fail) to a credit manager who decides whether the company or lender will extend credit. The referral may help with discussions and negotiations between the credit manager and the consumer.


6. What happens if you are denied credit or don’t get the terms you want?

If creditors deny you credit, the Equal Credit Opportunity Act requires the creditor to give you a notice that tells you the specific reasons the creditor rejected your application. You have the right to learn the reasons if you ask within 60 days.

Indefinite and vague reasons for the denial are illegal, so ask the creditor to be specific. Acceptable reasons include: “Your income was low” or “Your employment time is too short.” Unacceptable reasons include: “You didn’t meet our minimum standards” or “You didn’t receive enough points on our credit scoring system.”

If a creditor denied credit because you are too near your credit limits on your charge cards or you have too many credit card accounts, you might want to reapply after paying down your balances or closing some accounts. Credit scoring systems consider updated information and change over time.

Sometimes you can be denied credit because of information from a credit report. If so, the Fair Credit Reporting Act requires the creditor to give you the name, address, and phone number of the credit reporting agency that supplied the information.

You should contact that agency to find out what your report said. This information is free if you request it within 60 days of being turned down for credit. The credit reporting agency can tell you what’s in your report, but only creditors can tell you why they denied your application.

If you’ve been denied credit or didn’t get the rate or credit terms you want, ask if they used a credit scoring system. If so, ask what characteristics or factors they used in that system, and the best ways to improve your application.

If you get credit, ask the creditor whether you are getting the best rate and terms available and, if not, why. If you are not offered the best rate available because of inaccuracies in your credit report, be sure to dispute the inaccurate information on your credit report.

Go here for in-depth information on disputing and correcting credit reports

*The Better Credit Scores information outlined above is courtesy of TrueCredit.