A Quick Primer of Credit Scores
There are three major credit-reporting agencies in the United States. Each one provides pretty much the same information to consumers. This is because all use the same formula to arrive at a numerical credit score.
The information that goes into a credit score encompasses several categories, all of which relate to past financial behavior. That behavior provides insights into credit risk. Good credit means a better chance of loan approval. Bad credit makes obtaining a loan more difficult.
The Contents of Credit Reports
In the U.S., the three major credit-reporting agencies are Equifax, Experian, and TransUnion. In addition to using the same process in determining credit scores, reports from all three contain the same basic information, although formats vary:
- Social security number
- Date of birth
- Employment information
- Credit accounts (credit cards, car loans, mortgages, home equity loans and such) as well as opening dates, loan amounts, balances, and payment histories for each
- Credit inquiries for the previous two years
- Public records and collection actions on overdue debts, foreclosures, judgments, bankruptcies, wage attachments, and liens
Information contained in credit reports is not always correct or up to date, so periodically checking it is a good idea, especially since everyone is entitled to a free copy of their credit report each year.
The FICO Scale
Back in 1958, right around when credit cards began appearing in full force, Fair Isaac Corporation (a/k/a FICO) began developing a standardized credit reporting system. By the eighties, they had an efficient system that came to be known as the FICO score, “…the first general purpose credit risk score for use not just by lenders, but any business that was extending credit.” FICO now dominates in the credit-scoring realm, and is used in over 90 percent of lending decisions in the United States.
FICO scores range between 300 and 850. Higher scores mean an increased ability to qualify for loans at lower interest rates. The national average FICO® Score is 695. However, every lender interprets the numbers according to their own standards, giving more weight to one contributing factor over another. Nonetheless, FICO provides a general framework of scores and rankings.
- Less than 580
- Well below the average score of U.S. consumers
- Indicates a risky borrower
- 580 – 669
- Below the average score of U.S. consumers
- 670 – 739
- 740 – 799
- Very Good
- Above the average of U.S. consumers
- Indicates a very dependable borrower
- Well above the average score of U.S. consumers
- Indicates an exceptional borrower
Every borrower has several different scores, depending upon the provider as well as the industry seeking credit information. FICO® Auto Scores provide the data sought by auto lenders, whereas most credit card companies use FICO® Bankcard Scores or FICO® Score 8.
What Affects Credit Scores
FICO scores take into account both positive and negative information from credit histories. Information goes into five categories. Each has a different weight in terms of overall creditworthiness.
- Payment history is the greatest consideration in a credit score, accounting for 35 percent of the overall figure. It reports past behavior in paying credit accounts on time (hugely important to lenders).
- Amounts owed are another important consideration, making up 30 percent of an overall score.
- The length of available credit history plays a smaller roll (15 percent), but a longer history of open and current accounts as well as when accounts were last used may impact ratings.
- Credit mix in use is a smaller consideration, and looks at the different types of accounts used, from retail accounts to home mortgages.
- New credit is another lesser factor used in calculating credit scores. Opening several new loan or accredit accounts in a short time period may indicate higher risk for lenders.
The big question for many is how losing a home through foreclosure affects credit ratings.
Foreclosure’s Effect on Credit Scores
Individuals dealing with a foreclosure often also face an array of other financial issues potentially damaging to their credit rating. The circumstances leading to foreclosure vary, from job loss to medical disability to adjustable mortgages the kick up into the next interest rate. People in foreclosure may fall behind on credit card payments and car loans. At the same time, they may take out additional credit cards to try to make ends meet.
All of these things take a toll on credit ratings, especially defaulting on a mortgage. Surprisingly, in terms of credit score numbers, there is little difference in the negative impact on credit whether a house is lost through deed in lieu of foreclosure, short sales or foreclosure. According to an article in the Washington Post, quoting a FICO executive, “All of those events represent a loan default and as such are highly predictive of future credit risk.”
However, there is one option offering potentially better outcomes both in the short and long terms. In some cases, lenders may deem a credit history with a short sale as better than a foreclosure. This is true despite credit score numbers that look the same.
A 2011 report put out by FICO assessed how different financial events changed credit scores. The chart above illustrates the report’s findings. Additionally, FICO pointed out that the amount a score changed due to any event depends a lot on the individual’s beginning credit score, the lack of difference in score change due to short sales, deed-in-lieu/settlement, and foreclosure.
Repairing Credit Scores
There are several things to keep in mind when working to repair credit scores:
- It may take seven to ten years to fully recover (this assumes all obligations are paid as agreed)
- Generally, it takes longer to restore higher scores
- Despite little difference in the numbers after moderate and severe delinquencies, the time required to recover fully may be significantly longer.
Recovering credit is possible, even after a home foreclosure. However, financial repair will not occur immediately, and requires a lot of self-discipline. However, it can happen.