Since The Fair Credit Reporting Act in 1970, the United States government has regulated legislation pertaining to the fair and accurate recording of credit scores by credit reporting agencies. The three national credit bureaus, Experian, Equifax and TransUnion, utilize credit-scoring systems to mark the potential debt delinquency risk of a borrower. While each credit-reporting agency may use a different formula to generate a credit rating, the factors that affect scores are generally the same.
The most common credit scoring models are the FICO score, VantageScore and CE Score. All three models have a scoring range between 350 and 850. Most lenders consider individuals with a credit score higher than 750 as excellent prospects and those with scores between 700 and 749 as good. Individuals with a good or excellent credit score may receive perks from creditors such as a lower interest rate, since they have a proven history of reliability.
A fair credit score ranges from 650 to 699, and banks consider this as average credit. While individuals with a fair credit score can receive a requested loan, the interest rate is not likely to be competitive. Borrowers with a score between 550 and 649 are considered risky, and lenders may require a larger down payment or have higher interest rates before approval. Loan applicants with a score lower than 549 have a very poor credit score and are not likely to receive a loan on credit.
The most influential factors that affect credit scores are payment history, total debts owed and percent of credit limit utilized. Payment history of past credit accounts composes 35 percent of a borrower’s credit score. For instance, reoccurring late payments, particularly those over 90 days late, can reduce a credit score by 50 or more points and consequently drop a borrower’s rating into a lower bracket.
The credit utilization rate, or the total debt owed compared to the total available credit, impacts up to 30 percent of an individual’s credit score. By means of example, a borrower with a total available credit amount of $10,000 and total debt amount of $1,500 will have a higher score than a similar borrower with a total available credit amount of $10,000 and total debt amount of $8,500.
Having a low credit utilization ratio shows lenders that the individual knows how to manage debts by not overspending. Credit bureaus penalize the scores of individuals who utilize more than 30 percent of their available credit.
Length of credit history and type of debt owed affect 15 and 10 percent of the credit score, respectively. Length of credit history is the age of an individual’s oldest open credit account. If an individual has had a credit card for 10 years and another for only two years, he or she has a credit history of 10 years.
However, if the same individual closes the decade-old card, his or her credit history will correspondingly drop to two years. Debtors with a longer credit history are more favorable to lenders because they have a more accurate assessment. FICO needs at least six months of credit history on one account to formulate a rating.
Type of debt refers to the account category, which can include:
- Student loans.
- Credit cards.
- Utility accounts.
- Signature or personal loans.
Scoring models label some debt accounts as good or bad depending on the type. Good debts are those that increase an individual’s net worth, such as a mortgage when purchasing a home or student loan to increase earning potential.
Bad debts are those that have no lasting value, like credit cards issued by lending businesses and stores for consumer purposes. A borrower with a mortgage greater than $400,000 will have a better score than a consumer with only $5,000 on a credit card, since the first debt is an investment with a potential pay out upon sale while the latter is not.
Credit Score Examples
Twins Alex and Sam apply for credit cards when they turn 18 years of age and each receive a credit limit of $300. Alex purchases gasoline on the card and pays off the balance at the end of the month. Sam buys the latest video games and pays the minimum balance late most months.
When the twins apply for auto loans for new cars a few years later, the lender offers Alex, who has a credit score of 705, an interest rate of six percent with no down payment. The lender denies Sam, who has a credit score of 605, the requested amount. Sam reapplies for a lower amount for a used car, which has a nine percent interest rate and requires a $2,000 down payment.