As lending decisions have become increasingly automated, credit scores have become essential tools for creditors evaluating borrowers. FICO scores, the most commonly used, range from 300-850, and are derived by the credit bureaus from the information in a credit report. As each of the credit bureaus uses its own information to derive the credit score, scores often vary between bureaus. A score below 600 is widely considered subprime, a score above 650 is widely considered prime, and scores in between are treated differently depending on the lender. Credit scores are not provided as part of the free annual credit report consumers may obtain, but may be purchased from each bureau for a nominal fee.
How Credit Scores Are Determined
The FICO score is a proprietary credit scoring method developed by Fair Isaac Corporation. Many individual factors play a role in the final score, however Fair Isaac has provided a general breakdown as follows:
Payment History – 35%. Approximately 35% of a FICO score is based on payment history. This includes late payments, charge-offs and lawsuits as well as on-time payments.
Money Owed – 30%. Approximately 30% of a FICO score is based on amounts of debt. The debt-to-income ratio plays a role, as do debt-to-credit limit ratios. It is generally best to hold a variety of accounts with low balances rather than a account that is at the limit. However, holding too many credit cards can also be detrimental.
Length of Credit History – 15%. It is important not to close those very old accounts, as the length of credit history is generally based on the opening date of the oldest still-open account.
New Credit – 10%. Obtaining new accounts or otherwise having too many credit checks performed can lower the credit score. The theory is that searching for multiple sources of credit simultaneously can indicate financial distress.
Types of Credit – 10%. The FICO score is also based on the number and types of credit accounts (mortgage, credit cards, retail installment loans, etc.) the consumer has in his or her history.
Credit Score Accuracy
Research has shown that credit scores sometimes vary widely between credit bureaus because of differences in the information on the bureaus’ reports. A 2002 joint study by the Consumer Federation of America and the National Credit Reporting Association found that the average range was 41 points between the highest and lowest scores for the same person.
Discrepancies like this can result in significantly higher subprime mortgage rates for customers whose credit scores fall just below a lender’s prime cutoff. The difference could amount to thousands of dollars over the life of the loan.