A credit score is a number, generally between 300-850, assigned to you to rate how risky a borrower you are--the higher the score, the less risk you pose to creditors.
Your credit score plays a vital role when lenders decide whether to extend you credit. According to Fair Isaac Company, over 75 percent of mortgage lenders and over 90 percent of credit card lenders use credit scores when making their lending decisions. A low credit score may result in a denial of credit. Furthermore, lenders will charge higher interest rates on loans to individuals with lower scores. This practice is known as risk-based pricing.
In addition, your credit score is used in decisions beyond lending matters. Employers, utility service providers, among many others, use credit scores to evaluate whether to offer their services to individuals, and uses for the credit score continue to expand. Perhaps the most troublesome recent use of the credit score is by insurance companies to establish rates. In short, the decisions relating to whether you receive even the most basic services comes down to this single number.
Equifax, Experian, and Trans Union dominate the credit reporting business. These three agencies use three different models for credit scoring. Fair, Isaac and Company develops scoring models for Equifax and Trans Union, which is why they are also called FICO scores. Experian will start to use models developed by Scorex, with whom they merged.
Credit scoring models are developed by analyzing statistics and picking out characteristics that are believed to relate to creditworthiness. Credit Reporting Agencies (CRA) use different scoring models for different purposes. Auto financing, for example, could employ a different model than installment loans. Credit scoring models have long been shrouded in secrecy. Individuals and consumer advocates have found it difficult to ascertain information regarding what factors the models consider, and to what degree. It was only until recently that individuals could even obtain their own score. There is still no general federal legal obligation on CRAs to provide credit scores to individuals. However, some credit services companies now sell the credit score and advice for improving it for a fee.
The Equal Credit Opportunity Act forbids creditors from considering race, sex, marital status, national origin, and religion. Lenders and other institutions argue that credit-scoring systems provide a consistent, mathematical system to evaluate individuals. Institutions argue that a credit score is superior to the previous method of evaluation by a loan officer because the loan officer was given too much discretion, which gave rise to problems such as bias. Others argue that the disparate loan denial ratio has not changed since the implementation of the credit score, and the outright discrimination of the past was simply replaced with a more subtle form of discrimination that is built into the credit scoring calculations through the programmers' judgment calls regarding which factors to consider, and the amount of weight assigned to these factors.
Credit scoring models compute your score primary from information contained in your credit report. The models might also take information from credit applications into consideration, including your occupation, length of employment, and whether you own a home.
According to Fair Isaac and Company, your payment history accounts for approximately 35 percent of your credit score. Your payment history reflects the various accounts that you have, including credit cards, mortgage loans, and retail accounts. Collections, foreclosures, lawsuits, and other collection items also fall into this factor.
The amount of money that you owe approximately accounts for 30 percent of your credit score. The manner in which a credit score reflects this amount, however, is complicated. As Fair Isaac explains, "Part of the science of scoring is determining how much is too much for a given credit profile." The credit score takes into account your last reported balance, whether or not you pay the balance off in full. The score pays particular attention to the amount you owe in revolving credit" such as credit cards. For example, if you have several credit cards with a small balance that you pay off regularly, then this reflects better on your score than if you had the same number credit cards with no balance, because the latter shows a greater likelihood of "maxing out"those cards. In the same vein, if you have too many credit cards it will reflect poorly on your credit report.
Ten percent of your score falls under a category that Fair Isaac categorizes as "new credit." This category reflects factors such as the number of new credit accounts on your credit report. The more new accounts you have open, the more poorly this reflects on your score. In addition, the number credit checks that are run on you in the past year can actually reduce your score. This assumption is that, if you are searching for more credit, then you are a greater credit risk.
Fifteen percent of your credit score measures the length of your credit history under Fair Issac's system. Finally, approximately 10 percent of your credit score evaluates the type of credit you have and whether it is a "healthy mix."
These factors are just a few among many, and your credit score is determined by a complex formula that takes into account over 100 different factors.
While different lenders may evaluate scores differently, generally, a score above 680 is considered to be prime. Individuals with scores between 680-575 are likely to receive subprime loans, and individuals with scores below 540 will generally be denied credit altogether. If the individual is listed as having filed for bankruptcy, it results in a 160-220 point deduction on their credit score. A bankruptcy will remain on a credit score for 7-10 years. If a delinquent account is added to the individuals credit file, 70-120 points are subtracted.
Individuals with higher credit scores are offered different services than those with lower scores. Individuals with lower credit scores are targeted with subprime loans with higher interest rates. To illustrate the way in which credit scores effect interest rates, the Center for Community Change explains that individuals in the top credit score tier, +720, will generally pay 5.546 percent for a $100,000 mortgage carrying a monthly payment of $572. If extended credit at all, an individual with a credit score under 559 will pay 7.945 percent on the same mortgage, carrying a monthly payment of $730.
Furthermore, subprime and predatory loans are disproportionately made to minorities. According to the NAACP, African-Americans in all economic groups are disproportionately targeted with subprime and predatory loans. If an individual has a subprime loan on their credit report, it can damage their credit score. The lower score, in turn, attracts more subprime loans, resulting in a vicious cycle.
Expanding the Use of Credit Scores
More services use credit scoring to evaluate their customers. As such, individuals with low credit scores are finding it more difficult to obtain good and services.
Perhaps the most controversial new users of credit scores are insurance companies. Insurance companies are using credit scores to assess risk levels and loss ratios. Insurers believe that customers with low credit scores are more likely to make insurance claims. Despite the lack of a causal link between a credit score and insurance risk, insurance companies nevertheless can raise an individual's rates or even deny coverage based this number. For example, whether or not you have an outstanding loan can cause your auto insurance premiums to increase, even if you have a perfect driving record. Critics charge that this use of a credit score is completely arbitrary and it is an unfair business practice.
Certain states have attempted to take action against insurance companies using credit scores. In California, lawmakers defeated a bill that would have banned insurance companies from using credit scores to set rates and deny insurance. An Alabama regulation in its final stages that would prohibit insurers from considering an individual's lack of credit history.
Inaccuracies in Credit Reports
Since credit scores are so important, it is imperative that the scores be based on accurate information. However, inaccuracy problems continue to hurt individuals' credit scores. An extensive study conducted by the National Credit Reporting Agency and the Consumer Federal of America revealed that 29 percent of individuals had significant errors in their credit report that translated into a 50-point or more error in their credit score. CRAs receive a vast amount of complaints, and they do not devote adequate resources to property address complaints. Representatives at Experian, for example, are required to address 100 complaint calls per day.
Furthermore, CRAs are more concerned with amassing a large quantity of information about an individual because this is what the subscribers demand. This practice compromises data quality because when retrieving information about an individual, CRA algorithms are designed to discard minor differences that occur in identifiers, such as incorrect digits in a social security number. For example, in a case against Trans Union, the CRA regularly mixed the files of Judy Thomas with Judith Upton. These files were mixed because of the similarities in first names (CRAs tend to link women by their first names to track them if they change their names in marriage), and because their Social Security Numbers were very similar. The presumption here is that it is better to gather more information and err on the side of inclusion then to risk excluding bad credit information about an individual. The potential resulting problem is a mixed file, where CRAs combine information from different individuals into one file.
Credit report inaccuracies also come from information suppliers. In 1999, several banks admitted to withholding positive information about individuals so that their customers would not be lured away by competitors offering better credit terms. A 1999 Office of the Comptroller of the Current press release reads: "Some lenders appear to have stopped reporting information about subprime borrowers to protect against their best customers being picked off by competitors."
Individuals with inaccurate credit reports will in turn have inaccurate credit scores. They are denied credit, or charged higher interest rates, at no fault of their own.
- Study Indicates Mortgage-Rate Bias Against Blacks, Seniors, Washington Post, December 11, 2003.
- Subprime Lenders Target Minorities, CNN Money, May 1, 2002.
- Stephanie Brenowitz, Consumers Gain Access to Credit Number, The Columbus Dispatch, March 20, 2001.
- Terry Savage, Credit Score Has Key Part in Loan Decisions, Chicago Sun-Times, April 18, 2002.
- Marilyn Melia, The Rating Game, Chicago Tribune, January 5, 2001.
- Thomas Fogarty, Don't Let Your Credit Score Strike Out, USA Today, March 28, 2002.
- July 9th House Financial Service Committee Testimony Hearing Page.
- U.S. PIRG - Credit Reporting.
- Race and Age Discrimination in Lending Documented, National Community Reinvestment Coalition, December 2003.
- Credit Score Accuracy and Implications for Consumers (PDF), National Credit Reporting Association (NCRA) and the Consumer Federation of America (CFA), December 2002.
- Race or Risk? Center for Community Change, May 2002.
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Communications Law and Policy
Jerry Kang and Alan Butler