annual credit report

Lenders, such as banks and credit card companies, use credit scores to evaluate the potential risk posed by lending money to consumers and to mitigate loss to bad debt. Lenders use credit evaluations to determine who qualifies for a loan, assign an interest rate, assign credit limits and manage accounts that are already open (for example, treatment of accounts that are in default). The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system. While the most widely-known score in the United States is FICO (which is most widely used in the mortgage industry), there are many others, such as NextGen and Vantage Score.

The FICO score and others

FICO is an acronym for Fair Isaac Corporation (traded publicly under the symbol FIC) and refers to the best-known credit score model in the United States, which is calculated using mathematical formulae developed by this company. The FICO score is primarily used in the consumer banking and credit industry. Banks and other institutions that use scores as a factor in their lending decisions may deny credit, charge higher interest rates or require more extensive income and asset verification if the applicants credit score is low.

FICO scores are designed to indicate the likelihood of a borrower being delinquent within the next 24 months. No public information is available to determine what the scores mean in terms of statistics. A separate score, BNI, is used to indicate likelihood of bankruptcy.

The three major credit reporting agencies (also often, but inaccurately referred to as credit bureaus) in the United States, (Equifax, Experian and TransUnion) calculate their own credit scores, which go by different trademark names as well as many different versions of the score (often differing because of what they are meant to predict and when they were written): Beacon, Beacon 96, and Pinnacle are all available only from Equifax; Empirica, Empirica Auto 95, Precision Score, and Precision 03 at TransUnion; and Fair Isaac Risk Score at Experian. These versions, while all developed for the agencies by Fair Isaac, differ and are periodically updated to reflect current consumer repayment behavior. The NextGen Scores are the most recent scores, but creditors vary in which version they prefer to use.

The scores use a multiple scorecard design. Each version uses 10 or more individual scorecards, and an individual is typically compared with similar others. (For example, a borrower with two 30-day late payments will be scored against a population with some minor delinquencies.) An individual is then graded according to what variables seem to indicate a repayment risk in that group. This feature may cause a borrower with delinquencies to score in the same range as a borrower without delinquencies.

Nearly all large banks also build and use their own proprietary statistical models for credit scoring purposes, often in conjunction with the FICO score or other outside scores.

The statistical models that generate credit scores are subject to federal regulations. The Federal Reserve Board's Regulation B, which implements the Equal Credit Opportunity Act, expressly prohibits a credit scoring model from considering any prohibited basis such as race, color, religion, national origin, sex, or marital status. Regulation B also stipulates that credit scoring models must be empirically derived and statistically sound. Furthermore, if an adverse action is taken as a result of the credit score (e.g. an individual's application for credit is denied) then specific reasons for the denial must be provided to the individual. A statement that the individual "failed to score high enough" is insufficient; the reasons must be specific.

There exist several generally accepted algorithms for extracting the primary contributing factors to a low credit score. One or more of these algorithms is typically used to supply a list of reasons when a loan applicant has been denied credit, in order to satisfy the Regulation B requirement that specific reasons are disclosed. Some consumers feel these adverse action reasons are somewhat disingenuous, as the only determining factor for credit denials is a numeric score — the "reasons" are summed up only for the consumer.

Each of the credit reporting agencies has developed its own version of the credit score intended to compete with Fair Isaac's score. Although not as widely used, these scores (for example Trans Union's "TransRisk" score or Experian's "ScoreX" and "PLUS" scores) are less expensive than the FICO score. These scores are often derisively referred to by consumers and lenders as "FAKO" scores, for they do not use official Fair Isaac methodologies. The cost savings of a non-FICO score are tempting to some banks and credit card companies, who need an accurate risk assessment on millions of accounts every year. For ease of use, these scores tend to be mathematically scaled so that they fall in the same general range as the FICO score. Fair Isaac offers scoring models for the U.S., Canada, and South Africa. It also offers a "Global FICO" for many other countries.

Makeup of the credit score

Credit scores are designed to measure the risk of default by taking into account various factors in a person's financial history. Although the exact formulae for calculating credit scores are closely guarded secrets, Fair Isaac has disclosed the following components and the approximate weighted contribution of each:

• 35% punctuality of payment in the past (only includes payments later than 30 days past due)
• 30% capacity used: the ratio of current revolving debt (credit card balances, etc.) to total available revolving credit (credit limits)
• 15% length of credit history
• 10% types of credit used (installment, revolving, consumer finance)
• 10% recent search for credit and/or amount of credit obtained recently

The above percentages provide very limited guidance in understanding a credit score. For example, the 10% of the score allocated to "types of credit used" is undefined, leaving consumers unaware what type of credit mix to pursue. "Length of credit history" is also a murky concept; it consists of multiple factors - two being the oldest account open and the average length of time an account has been open. Although only 35% is attributed to punctuality, if a consumer is substantially late on numerous accounts, his score will fall far more than 35%. Bankruptcies, foreclosures, and judgments affect scores substantially, but are not included in the simplistic pie chart provided by Fair Isaac.

Further, Fair Isaac does not use the same "scorecard" for everyone. The scorecards are segmented so that there are over 100 different actual scoring models that are applied to different individuals based on different ranges of input values (some scorecard segmentations include: age, depth of credit history, etc.) The implications of this segmentation are that while the approximate weighted contribution above may be an average across all scorecards, individuals will receive different scores or weightings based on the scorecard segmentation that they fall into. Some consumers have noticed their scores decreasing by small amounts for no apparent reason.

Current income and employment history do not influence the FICO score, but they are weighed when applying for credit. For instance, an unemployed individual with no other sources of income will not usually be approved for a home mortgage, regardless of his or her FICO score.

There are other special factors which can weigh on the FICO score.

• Any monies owed because of a court judgment, tax lien, or similar carry an additional negative penalty, especially when recent.
• Having above a certain number of consumer finance company credit accounts also carries a negative weight (critics say that this causes a vicious cycle, locking people into continuing to use consumer finance companies).
• The number of recent credit checks also can weigh down the score, although the credit agencies claim to allow for credit checks made within a certain window of time to not aggregate, so as to allow the consumer to shop around for rates.

Range of scores

A FICO score generally ranges from 300 to 850. It exhibits a left-skewed distribution with a US median around 725. 660 is generally regarded as potentially subprime and represents an important break point for credit worthiness. The performance of the scores is monitored and the scores are periodically aligned so that a credit grantor normally does not need to be concerned about which score card was employed.

Each individual actually has three credit scores for any given scoring model because the three credit agencies hold their own, independent databases. These databases are independent of each other and may contain entirely different data. Many lenders will check an applicant's score from each bureau and use the median score to determine the applicant's credit worthiness.

A new Vantage score has been offered by all three credit bureaus to creditors since spring 2006. It will soon be available to debtors. Its range is from 501 to 950. It is graded A (901-950), B (801-900), C (701-800), D (601-700), and F (501-600). It remains to be seen whether the Vantage Score will replace the FICO score or even be accepted by many creditors.

Free annual credit reports

As a result of the FACT Act (Fair and Accurate Credit Transactions Act), each legal U.S. resident is entitled to one free copy of their credit report from each credit reporting agency once every twelve months. This information is available at the government-sanctioned but credit bureau-operated AnnualCreditReport.com, by calling 1-877-322-8228, or by mailing the Annual Credit Report Request Form. To guard against inaccurate information or fraud more often than yearly, request only one report from a different credit bureau each four months. However, the free report does not contain a credit score. A credit score may be purchased at the time of access for a nominal charge. Requesting a credit report will subject you to 'pre-screened' offers of credit cards. To prevent all three credit bureaus from making your address available to credit card companies for this purpose, you may opt-out by calling 1-888-5OPTOUT (1-888-567-8688).

Non-traditional uses of credit scores

In September 2004, a Texas utility company announced it would begin setting individualized electricity prices based on credit score. However, due to negative press and pressure from the Texas Public Utility Commission, the plan was not implemented.

Credit scores are used in determining prices for auto insurance. Recently, some of the agencies which generate credit scores have also been generating more specialized insurance scores, which insurance companies then use to rate the quality of potential customers. These scores are unavailable and opaque to consumers.

Many employers now reserve the right to do a credit check of job applicants, in the same manner they reserve the right to drug test potential employees.

See also

• Fair Credit Reporting Act (FCRA)
• Credit history
• Adverse Credit History
• Credit card
• Credit rating agency
• Identity theft

External links

• US Government FAQ about FACT
• Text of Regulation B, which stipulates the conditions that US credit scoring models must satisfy

• PBS FRONTLINE "Credit Scores: What You Should Know About Your Own," by Malgorzata Wozniacka and Snigdha Sen (November 2004)