Lesson 3: How Credit Scores Work

Summary:

Learn how the system works, then make it work for you
Your credit report is basically your history of repaying debt (but it could be inaccurate)
Credit scores are calculated by analyzing information from your credit report using an algorithm (the exact formula is a secret, but we know the main factors used)
Most lenders use the FICO® Scoring model to make lending decisions
The VantageScore model is an invention of the credit bureaus and widely available for free
Both models use the same basic factors, but the scores are calculated differently, giving you different scores (VantageScore is often 30 points higher than FICO® Scores)
The main factors are:
- Your payment history (35% of your score)
  - Pay your accounts on time
  - Avoid collection accounts
- Your Utilization ratio (30% of your score)
  - Usually 1% to 6% is best
- The length of time your accounts have been open (15% of your score)
  - Over 4 years will give the most points
- New credit inquiries present on your report (10% of your score)
  - FICO® Scores only use inquiries within the past 12 months as a factor
- The mix of different accounts on your credit report (10% of your score)
  - Term-loans are different from revolving accounts
If you have one account (good or bad) you have a credit score

Wise Credit Management is a free Bible-based class that teaches how credit really works by showing factual information directly from the Credit Bureaus and FICO, and simplifies the subject to show everyone how to build good credit or handle bad credit. The class is fairly comprehensive and focused on getting good credit to qualify for a good mortgage rate and terms. WiseCreditManagement.com is a free community for members to take the class, join local groups (online or in person) for mutual support, and to find local professionals who volunteer to use their skills to assist members to success.

I am not a lawyer or Credit Repair Organization.

Home ownership is the way most Americans build wealth and a lack of education about credit is a huge contributor to the growing “Wealth Gap” in our country. Wise Credit Management is focused on teaching how to get good credit and qualify for a good mortgage rate and terms.

My work is protected by the “fair use” section of U.S. Copyright Act.

Proverbs 3:5-6 teaches us to ~ trust the Lord, lean not on our own understanding and in all our ways acknowledge Him, and He will direct our path. ~

You do not need to understand exactly how the scoring models work. Just do the right thing over a long period of time and your scores will keep getting higher.

Credit Scores

In Lesson 1, we looked at how the credit system works, and Lesson 2 was about how to get and read your own credit report. Now we will take a deep dive into actual credit scoring and the factors that are used to calculate your credit score. Before we begin, you should know that the actual mathematics are complicated and use “algorithms” to arrive at your final score. Furthermore, the formulas used to calculate your score are trade secrets of the company that created it, so all we have to go on is the basics they give us. From that we can develop a very good idea of what is most important to our scores and what we should do to increase them.

The Federal Trade Commission (FTC) says, “A credit report is a summary of your personal credit history.” When a lender does a credit “Pull” or “Inquiry” from a bureau, your credit report will be put through the algorithm and get a score based on the history provided by that bureau. There are three different Credit Bureaus and you will have three different scores, one from each bureau.

myFico.com (myfico.com/credit-education/credit-scores/whats-not-in-your-credit-score) gives a list of factors that are not considered in the calculation including: Race, Gender, Age, Employment Status, Looks/Clothes and your Charming Personality (I added that one).

I want to emphasize that race/ethnicity is not a factor in your score. However, I do recognize that there is a significant difference in the average credit score among different races. That is a socioeconomic problem and not a problem with the algorithm itself.

In Lesson 1 we learned that credit history is the way future lenders determine how risky it will be to lend you money. What is the definition of a credit score? “Credit Scores are an objective way to calculate risk based on credit history.”

What is a good credit score? Many people use general scoring ranges to categorize consumers into groups to describe how people in that particular group look to lenders. The top scoring group is called Exceptional with a range of 800 to 850. Just below that is Very Good with a range of 740 to 799. Then Good with a range of 670 to 739. Fair credit is between 580 and 669. And Poor credit is between 300 and 579. These scores are designed to predict your risk of becoming seriously delinquent. Historically, for real estate loans the risk of delinquency within the first two years is almost 28% for a borrower whose score is under 600.

Real Credit Score

What people usually refer to as their “real” credit score is the FICO® 8. You can get that score based on your Experian credit report from the Experian App. Another widely used App for credit monitoring is CreditKarma, which gives your VantageScore 3.0 for the other two bureaus.

What is the difference between FICO® and VantageScore? VantageScore is a real credit score developed by the three major credit bureaus and those scores are typically 30 points higher than FICO Scores which are the scores that most lenders use to determine risk. I have seen that many times in personal experience, and I found a reference to it as shown in the website excerpt below:

What qualifies as a good score can vary from one creditor to another. However, on the 300-to-850 scale, a score of at least 670 (for FICO^®) and 700 (for VantageScore) will generally qualify as having good credit.

(https://www.experian.com/blogs/ask-experian/the-difference-between-vantage-scores-and-fico-scores/)

Stating that you need a 30-point higher score from VantageScore than FICO® to fall into the “good credit” category is a subtle reference to the idea that your VantageScores are usually 30 points higher than FICO® Scores. It’s not a bad thing, but many people get upset because VantageScores say their credit is better than FICO® and they are disappointed when a lender points that out after applying for new credit.

The FICO® Score was developed by William Fair and Earl Isaac in 1989 and soon became the industry standard by lenders. If you go to myFICO.com and pay for the monitoring you will get your FICO® Scores from each bureau, including your FICO® 8 and your Mortgage FICO® Scores (2, 4 & 5), which are different from the FICO® 8 scores because they score the factors from your credit report differently. There are several other FICO® Scoring models available (Credit Cards and Auto Loans), but we focus on managing your credit to end in home ownership, so we mainly refer to your mortgage score. Recently it was announced that the FICO® 10 T and VantageScore 4.0 will be accepted as credit scoring models for mortgages. However, at present those models are not widely used. When the industry begins wide use of those models for mortgage lending, I will spend more of your time discussing them.

5 Main Factors

What are the factors used to calculate your credit score? According to myFico.com, there are 5 main factors used to calculate your credit score: Payment History, Amounts Owed, Length of Credit History, New Credit and Credit Mix. They are weighted in the calculation differently. In a range of possible FICO® Scores of 350 to 850 there are 501 possible scores, though below 500 is highly uncommon no matter how bad the credit report is.

35% – Payment History

Thirty-five percent of your score (or about 175 points) is your Payment History on debt. Each account you have open for 1 month counts as a payment and if you are on-time (whether you have to make a payment or if no payment is due) it is reported as good or current. If you are more than 30 days late, the payment counts as late or not on-time. Your payment history is basically a ratio of on-time payments to the total payments you are obligated to make (on-time payment ratio). A collection account (perhaps a forgotten utility bill) can drop your score by 100 points and, based on data provided from the Illustrated FICO® Score Card, one late payment can drop your score as much as 65 points. The most important part of this factor is to make your payments on-time.

30% – Utilization Ratio

The second most important factor used to calculate your credit score is your Utilization Ratio. Thirty percent (about 150 points) of your score is based on the ratio of the current balance on your account to the high credit limit on the account. Utilization Ratio is usually measured as a percentage ($1.00 balance to a $100.00 limit = 1% Utilization Ratio on that account) and the lower the better because it indicates you can use credit responsibly. Based on data provided from the Illustrated FICO® Score Card, points are deducted from your score as your Utilization gets higher than 6%. A utilization ratio between 50% and 90% will reduce your score by about 40 points, and over 90% will reduce your score by 50 points. FICO does this calculation for both Revolving accounts (credit cards) and Term Loans (mortgage and auto loans). The most important part of this factor is to keep your credit card balances low.

15% – Length of Time

The Length of Time your accounts have been open accounts for 15% (about 75 points) of your score. This time is measured in months and considers the average age of all your accounts as well as your oldest and newest account. As the age of your account increases so does your score. Based on data provided from the Illustrated FICO® Score Card, you get a significant increase in your score after the first 12 months and another increase after 24 months, then the maximum increase is after 4 years. The most important part of this factor is to keep old accounts open because scores go up the longer you keep an account in good standing.

10% – New Credit

New Credit is a factor in 10% (about 50 points) of your credit score. When you apply for a loan, there is a “Hard Inquiry” made which will drop your score. If you apply to different companies for different accounts your score will drop even more. Based on data provided from the Illustrated FICO® Score Card, your score could drop as much as 50 points for 4 or more inquiries, however they only affect your score for the first 12 months, but remain on your credit report for 24 months (https://www.myfico.com/credit-education/credit-reports/credit-checks-and-inquiries). Your score is very sensitive to opening a new account and will drop significantly the first month a new account is open, but will begin to increase soon and be back to where it was before in 3 to 6 months. The most important part of this factor is understanding that new credit will drop your score with both an inquiry and drop your credit age, so only apply for new credit when necessary.

10% – Credit Mix

The last factor is your Credit Mix, which accounts for 10% (about 50 points) of your credit score. Your FICO® Scores will benefit from having multiple types of accounts like credit cards, auto loans and mortgages. Additionally, it’s worth noting that bank-issued credit cards are in a different category from store cards. Bank issued cards increase your score more because a bank is lending its money to you through the credit card and it probably has higher standards than a store card which is selling you its own products at retail, so the store is really offering a promotion for its store and has less at risk. It is my opinion that you should have at least three bank issued cards and two term-loans on your credit report to build it. As your score increases over 700 you should try to keep the ratio somewhat consistent and perhaps you can carry six bank cards and five term-loans. The most important part of this factor is keeping a good mix of bank issued credit cards as well as term loans on your credit report.

If you have a Collection or Charge-Off in your credit report, it could drop your score by 100 points. Multiple delinquent accounts can hurt worse, and make it more difficult to get approved for a mortgage. We will discuss how to handle these accounts in Lesson 7 and the DIY Disputing class.

Your Credit Scores

If you are taking the class in sequence, you have your three credit reports from the main bureaus; Experian, TransUnion and Equifax. You are probably curious what your actual FICO® Scores are for each of these bureaus. There are multiple places you can get your FICO® 8 and FICO® 9 Scores for free with a membership. The Experian App has your Experian FICO® 8 for free, and Wells Fargo customers get their Experian FICO 9 for free. Navy Federal and Digital Credit Union offer Equifax scores to their customers for free and myFICO.com offers the Equifax FICO 8 Score for free with a membership. Credit Strong and Discover offer the TransUnion Fico® 8 Score for free.

A paid membership with myFICO.com shows your actual FICO® Scores from each bureau, including your Mortgage FICO® Scores. I strongly suggest you use this service to monitor your mortgage scores if you are considering buying a home in the next six months. You should at least know what your FICO® Mortgage scores (from the FICO® Models 2, 4 and 5) are before you apply. It’s like paying a $30 pre-application fee.

How often does your credit score change? Your score changes every time new information is given to the credit bureau and as every account you have gets a month older. Creditors usually report your account information (balance, minimum payment, etc.) monthly, but rarely will two companies report on the same day. So there are constantly changes made to your report and that new information will be scored the next time the algorithm performs its scoring calculation. The Experian App usually updates monthly or with an immediate major change to your report such as a new inquiry or new account. The CreditKarma App usually updates daily or with a major change. I have found that Bank Apps update monthly regardless of any change.

No Credit Score (not a “Zero” score)

Many people choose not to open credit lines. They try to avoid debt entirely. That is admirable and very difficult to do in today’s economy, and it will keep you out of most consumer debt. Unfortunately, accounts that you did not want on your credit report can be placed in your file, such as bad utility bills or medical bills. These can and will be placed on your credit report whether or not you have your credit file “locked”.

Will one bad debt give you a bad credit score? Yes, especially if you do not have good credit to compensate. If you are hoping to buy a home without a credit score, just know that one missed utility or hospital bill can give you a credit score, which will be bad and make it very difficult to get qualified for a mortgage. Additionally, not having a credit score makes it very difficult to get pre-qualified for a mortgage so most sellers won’t accept your offer on their home because you cannot prove a lender will approve your application. If a lender is willing to approve your application through manual underwriting it will likely be about 2% higher than if you followed the steps in Lesson 4: How To Build Good Credit.

If you have a credit score based on one or two lines of credit, such as a gas card or being an authorized user, you have a “Thin Credit File”. There are alternatives to using the FICO® 2, 4 & 5 model but you will have to find a lender that works with the alternatives. For example, CreditVision Link is provided by TransUnion and allows deposit account history and other accounts that do not traditionally get reported.

What is Trending Data in credit scores? The new FICO® 10 T (which stands for Trending) and VantageScore 4.0 use a concept that takes into account whether your balances have been recently increasing or decreasing to add that factor into your credit score. If you are paying down your debt consistently over the most recent few months you will have a slightly higher score than if the balances on your accounts were increasing. The new models also have the ability to score alternate data that traditional scores do not factor in, such as utilities and rent.

Proverbs 3:5-6 teaches us to trust the Lord, lean not on our own understanding and in all our ways acknowledge Him, and He will direct our path.

You do not need to understand exactly how the scoring models work. Just do the right thing over a long period of time and your scores will keep getting higher.

Next: Complete the Lesson 3 Quiz (first make sure you completed the Lesson 2 Quiz)