Old school of thought

When I first became a loan officer in a large financial institution, the credit report was a major tool lenders used to evaluate credit applications. The theory was what you did in the past determined what you would do in the future. In other words, if you paid your bills on time in the past, you would pay your bills on time in the future. Other elements of the approval process, such as how long you lived in one location, how long you worked at the same company, or whether you own or rent your house were also considered. However, these elements normally required human involvement. Someone had to view the application to consider these factors.

New school of thought

Today, in addition to a credit report, many lenders use a mathematical system to evaluate the credit worthiness of an individual. This system is called credit scoring. There are several scoring models lenders use. Perhaps the most popular system is FICO. Fair Isaac & Co. developed the FICO credit score in the late 1950's. It takes several factors into account to arrive at a credit score, including but not limited to:

· Number of accounts with balances
· Number of finance company accounts
· Delinquency reported on accounts
· Too few bank revolving accounts
· Too many bank revolving accounts
· Number of recent inquiries
· Number of accounts opened within last twelve months
· Number of accounts delinquent

Some lenders use the credit score alone to determine whether a credit request is approved or declined. Have you ever wondered how a discount store or department store could grant you credit is less than five minutes? Were you surprised when you went online and were approved in less than a minute. They used credit scores. There was no need to manually review a credit report.If your score met the minimum standard, you were approved.

Mortgage companies rely heavily on credit scores. Generally speaking, the higher the credit score, the lower the interest rate. FICO scores range between 300 and 850. Applicants with credit scores of 720 or higher require less paperwork or scrutiny, garner the lowest interest rates, and qualify for more loan programs. This is possible because individuals with the highest scores usually offer the lowest credit risks.

Why do lenders rely so heavily on credit scores?

Lenders rely on scoring because overall they are highly accurate. Credit scoring uses a mathematical algorithm or formula using information in your credit report compared to millions of credit reports of other individuals. The outcome of these huge comparisons is a highly accurate number that reflects the likelihood of you paying your bills. Additionally, credit scores tend to eliminate human bias or subjectivity, thereby making discrimination less likely to occur. Actually, under the Equal Credit Opportunity Act, credit scoring systems cannot use factors, such as race, marital status, sex, religion, or national origin.

Are credit scoring systems perfect?

No. Sometimes applicants who are actually a better risk are declined because they have a poor credit score. How is this possible? Suppose a $100,000 loan applicant does not believe in credit cards or car loans. Consequently, he or she pays cash for all purchases. As a result of this practice, there is a good chance his or her credit score will be less than 620. If the lender adheres solely to the standard set by the Federal National Mortgage Association (Fannie Mae), they will decline this loan application. Fannie Mae will not purchase a mortgage with a credit score less than 620. It will not matter that they have a retirement fund in excess of $500,000 or income in excess of $200,000. The credit score rules. So if you plan to finance the purchase of your house in the future, check your score now. If it is below 620, there may still be loans available for you, but they will likely come with a higher interest rate and tighter conditions.

How can I improve my credit score?

Credit scoring models are complex and vary, depending on the creditor and type of credit. For example, a scoring system used for a car loan will probably be different from the system used for a mortgage loan. Having said that, there are some known things models take into account; namely:

• What type of credit accounts do you have? Finance company loans are usually viewed unfavorably. The thinking here is that a person would only go to a finance company if they have been turned down by a bank or other less expensive source of borrowed funds.
• What is your outstanding debt? Many scoring models compare credit limits to outstanding balances. If you are 'maxed out' or near the limits on your cards, this is viewed negatively.
• Do you pay your bills on time? This should be obvious but paying your bills late will reduce your credit score. · How long has the account been open? The length of time an account has been open is considered in the scoring model.
• Have you applied for new credit recently? Too many credit inquiries may negatively affect your credit score.

Errors on your report may lower your score, so review your credit report annually. If you find errors, be sure to notify the main three credit bureaus, Experian, Equifax, and TransUnion. You may request one free credit report annually. To order a copy of your report, go to www.annualcreditreport.com or call 877-322-8228.