Credit Scoring Voodoo

Credit scoring is a method used by a creditor to decide whether or not to grant you credit. The credit scoring system is used to determine if you would be a good risk for credit cards, auto loans or evaluating a customers ability to repay a home mortgage. Depending on how you score a creditor may extend credit or turn you down. Here's how credit scoring works in helping decide who gets credit -- and why.

What is Credit Scoring?

Credit scoring is a system used by some creditors to determine whether to give you a loan or credit card. A creditor may look at your past credit history, how many accounts you have and their type, any late payments, outstanding debt, and other information to determine your credit worthiness. A credit scoring system awards points for each factor that the creditor considers important. Consumers with the most points are generally offered credit because those points help predict who is most likely to pay back the debt.

Why is a Credit Scoring System Used?

In smaller communities, shopkeepers, bankers, and others who extend credit often knew by word of mouth who paid their debts and who did not. As some creditors became larger and as the number of their consumer credit applications grew, these creditors needed to establish more systematic and efficient methods for evaluating which consumers were good credit risks. Credit scoring is one such technique. Although smaller creditors still may rely on informal credit evaluations, many large companies now use formal credit scoring systems. Although no system is perfect, credit scoring systems can be at least as accurate as informal methods for granting credit -- and often are more so -- because they treat all applicants objectively.

How is a Credit Scoring System Developed?

Most credit scoring systems are unique because they are based on a creditor's individual experiences with customers. Creditors select a random sample of its customers and analyze it statistically to identify which characteristics of those customers could be used to demonstrate creditworthiness. Each statistic is weighted based on how well each predicts who would be a good credit risk.

How is a Consumer's Application Scored?

To illustrate how credit scoring works, consider the following example that uses only three factors to determine whether someone is creditworthy. (Most systems have 6 to 15 factors.)

Example:

Monthly income	Points Awarded
Less than $400	0
$400 to $650	3
$651 to $800	7
$801 to $1,200	12
$1,200	+15

Age
21-28	11
28-35	5
36-48	2
48-61	12
61	+15

Telephone in home
Yes	12
No	0

Some credit scoring systems award fewer points to people in their thirties and forties, because these individuals often have a relatively high amount of debt at that stage of their lives. The law permits creditors using properly-designed scoring systems to award points based on age, but people who are 62 or older must receive the maximum number of points for this factor. If, for example, you needed a score of 25 to get credit, you would need to make sure you had enough income at a certain age (and, perhaps a telephone) to qualify for credit. Remember, this example shows very generally how a credit scoring system works. Most credit scoring systems consider more factors than this example -- sometimes as many as 15 or 20. Usually these factors are obviously related to your credit worthiness. Sometimes, however, additional factors are included that may seem unusual. For example, some systems score the age of your car. While this may seem unrelated to creditworthiness, it is legal to use factors like these as long as they do not illegally discriminate on race, sex, martial status, national origin, religion, or age.

How Valid is the Credit Scoring System?

With credit scoring systems, creditors are able to evaluate millions of applicants consistently and impartially on many different characteristics. But credit scoring systems must be based on large enough numbers of recent accounts to make them statistically valid. Although you may think that such a system is arbitrary or impersonal, a properly developed credit scoring system can make decisions faster and more accurately than an individual can. And many creditors design their systems so that marginal cases -- not high enough to pass easily or low enough to fail definitively -- are referred to a credit manager who personally decides whether the company will extend credit to a consumer. This may allow for discussion and negotiation between the credit manager and a consumer.

What Happens If You Are Denied Credit?

A creditor is not required to tell you the factors and points used in its credit scoring system but they must tell you why you were rejected for credit. This is required under the Equal Credit Opportunity Act (ECOA).

So if a creditor says you were denied credit because you have not worked at your current job long enough, wait a while and reapply after you have been at that job longer.
If you were denied credit because your debt-free monthly-income was not high enough, pay some of your bills and reapply.
Remember, also, that credit scoring systems differ from creditor to creditor, so you might be able to get credit if you applied for it elsewhere. Sometimes you can be denied credit because of a bad credit report.

The Fair Credit Reporting Act requires a creditor to give you the name and address of the credit reporting bureau that reported the information that resulted in a denial of credit. Contact that credit bureau to find out what your credit report said. This information is free if you request it within 60 days of being turned down for credit. Remember that the credit bureau can tell you what is in your report, but only the creditor can tell you why it denied your application.

You can also receive a free credit report by signing up with the Clean Credit© monitoring service. The report is completely free, available 24 hours a day, 7 days a week online. They only charge you if you use their service to dispute items on your report.