The History of Credit Scoring
The credit score system used today has evolved since the 1960s. It was originally designed to provide lenders with financial profiles on consumers who wished to borrow money.
The lenders' biggest concern was whether or not an individual had the ability to repay a loan,
and establish what percentage of risk might be involved. Congress passed the Fair Credit Reporting Act in 1971 to establish guidelines for fair practices in regard to the use of
credit scoring. This law was designed to promote accuracy in reporting and protect the privacy of consumers. In light of the increased use of credit scoring and a growing fear of identity
theft, recent legislation has been passed to further protect Americans and improve consumer awareness. The Fair and Accurate Credit Transactions Act of 2003 (sometimes referred to as The FACT ACT or FACTA) was signed by President George W. Bush on December 4, 2003.
This amended the Fair Credit Reporting Act, enabling each American to obtain one free credit report every 12 months from each of the three main credit reporting agencies (CRAs);
Equifax, Experian® and TransUnion®. Those bureaus have created a central web site, www.annualcreditreport.com, to accommodate Americans who wish to obtain copies of their
Why Your Credit Score is So Important
The credit scoring model seeks to quantify the likelihood of a consumer to pay off debt without being more than 90 days late at any time in the future. Credit scores can range between a
low score of 300 and a high score of 850. The higher the score, the better it is for the consumer, because a high credit score translates into a low interest rate. This can save literally
thousands of dollars in financing fees over the life of the loan. Only one out of 1,300
people in the United States have a credit score above 800. These are people with a stellar credit rating that get the best interest rates. On the other hand, one out of every eight prospective home buyers is faced with the possibility that they may not qualify for the home loan they
want because they have a score falling between 500 and 600.
The Five Factors of Credit Scoring
Credit scores are comprised of five factors. Points are awarded for each component, and a high score is most favorable. The factors are listed below in order of importance.
1. PAYMENT HISTORY – 35% IMPACT
Paying debt on time and in full has the greatest positive impact on your credit score. Late payments, judgments and charge-offs all have a negative impact. Missing a high payment will have a more severe impact than missing a low payment, and delinquencies that have occurred in the last two years carry more weight than older items.
2. OUTSTANDING CREDIT BALANCES – 30% IMPACT
This factor marks the ratio between the outstanding balance and available credit. Ideally, the consumer should make an effort to keep balances as close to zero as possible, and definitely below 30% of the available credit limit when trying to purchase a home.
3. CREDIT HISTORY – 15% IMPACT
This portion of the credit score indicates the length of time since a particular credit line was established. A seasoned borrower will always be stronger in this area.
4. TYPE OF CREDIT – 10% IMPACT
A mix of auto loans, credit cards and mortgages is more positive than a concentration of debt from credit cards only.
5. INQUIRIES – 10% IMPACT
This percentage of the credit score quantifies the number of inquiries made on a consumer's credit
within a six-month period. Each hard inquiry can cost from two to 25 points on a credit score, but the maximum number of inquiries that will reduce the score is ten. In other words, 11 or more inquiries within a six-month period will have no further impact on the borrower's credit score.
Note that if you run a credit report on yourself, it will have no effect on your score.
Remember that the credit score is a computerized calculation. Personal factors are not taken into consideration when a credit report is generated. It is merely a snapshot of today's credit profile for any given borrower, and it can fluctuate dramatically within the course of a week.