Automated credit scoring has had a greater impact on how loan applications are considered than any other change since the beginning of credit bureaus. Many consumers can tell you what their credit score is, but fewer have an accurate understanding of what their credit score number really means.
Credit scoring is not new or recent idea. In early “scoring” lenders used manual systems whereby “points” were assigned to certain characteristics within a loan application. For instance, over five years employment might rate ten points, less than two years might be assigned only one point. Each thirty day delinquency might be given a negative two. Points were totaled. An application might be approved or declined, or an interest rate determined based on what total points indicated about the risk level.
Improvement in this idea of risk prediction became possible as credit reporting became a national system with huge credit databases. Fair Issac and Company, now known as FICO, was an innovator in the standardized credit scoring industry, and remains dominant. It uses a model that draws information directly from the credit reporting repository to calculate a “score”, which has become a standard measure of the likelihood of loan default.
Consumers commonly misunderstand the meaning of their credit score. Perhaps because it’s called a “score”, they think it is a “report card” on their past behavior. While past payment history is a significant factor in determining a credit score, the score is actually predictive of future behavior. In developing the model, FICO analyzed millions of credit reports, and then looked at those consumers status two years later. By this means they were able to assess what those who defaulted and those who paid well had in common when originally analyzed. They then built the scoring model around those commonalities.
Widespread misunderstanding that credit scores are predictive, not reactive, leads to misunderstanding about how consumers can improve their score. While it does improve a score over time to pay off delinquent accounts and collections, it may damage scores to close accounts or consolidate several credit cards onto one. Other actions that can improve scores are keeping credit card balances below fifty percent of the maximum credit line, and being added as a borrower to a good account that a spouse or parent many have.
FICO and other scoring companies’ actual scoring models are proprietary and trade secrets, but they have provided insight into things consumers can do to improve their scores. Other businesses have developed credit score improvement plans based on analyzing the changes in scores relative to actions taken by consumers. There are many sources offering “credit score improvement” assistance for a fee and, while some are legitimate, others take a fee and produce little or nothing in the way of results. Consumers should be very cautious before paying anyone to help them improve a credit score.
Credit scores are in widespread use because they work, and they are here to stay. In addition to loan rates and availability, insurance rates and even employment opportunities can be affected by credit scores. Consumers and lenders need to know and understand what they are, what they are not, and what they need to do to maintain a good credit score.
The CBAO does not offer or endorse any credit score improvement program, but we do have a partner that offers unsecured business credit lines to applicants with good credit. As part of this program, credit score improvement assistance may be offered free of charge.
Submitted by Kyle Moseman, CBAO Product and Service Manager
