How Does Credit Scoring Really Work?
Credit scores are based on a consumer’s credit record maintained by the credit reporting agencies. Computers are used to analyze a person’s credit report data in order to generate a statistical number, referred to as a credit score.
This number is used as an indicator to the likelihood a person will pay the loan back.
When most of us think of scores, we think of relatively straightforward systems used in sports or in school tests. You get points or subtractions for certain actions, behaviors, or answers, and those are totaled to determine the score.
Credit scoring isn’t nearly as easy! Credit scoring models use multivariate formulas (meaning a ton of variables). To understand how this works, let’s use a noncredit example: Suppose your friend is late getting over to your house. Where the heck is he? To answer this question you need to review what you know about this person including, are they forgetful, do they often run late for things, have they ever been late to your house before? Are they walking or driving? Did they stop to get gas? Using all these variables you could try to predict where your friend is. The number of factors of the credit scoring formula evaluates is much greater, so you can see how difficult it can be to predict credit outcomes.
The massive algorithms and multivariate calculations compare groups of people based on similarities. Due to the grouping aspect of calculations, a credit score is not based on one’s individual credit, it is based on how an individual compares to others in the specified group based on prior statistical data.
This is an ever-changing model, for example- in the future a single like a foreclosure might not have as much of an impact as it did in the past if a larger amount of people with a foreclosure keep that foreclosure as an isolated incident that does not affect the rest of their credit.
This example is a prediction of what will happen in the future, based on what we see in today’s market. Many individuals that are facing foreclosure have maintained the rest of their credit; many are walking away because they feel over-leveraged or upside down.
If enough of these individuals maintain a strong credit rating after a foreclosure, the statistical data will show that a foreclosure doesn’t always negatively affect someone’s likelihood of repayment. The statistical data that changes the FICO scoring models could sometimes take years to adapt but, it is important to understand why and how the confusing calculations work.
Credit scoring originally focused on the decision to accept or reject an application for credit. Basically a “pass” or “fail” decision making system. Over time, it has expanded into other aspects of the lending process, including what interest rates to charge, the review of current account holders, and the solicitation of new loans.
What Comprises A Credit Score?
1. Payment History Accounts for 35%. Consumer payment history is the largest aspect of the credit score, as you might expect. In total payment history accounts for 35% of the total score. This aspect of the total score calculation is based on prior payment history with creditors.
Late payments, defaulted accounts, bankruptcies, and all other negative information on the credit report have the greatest effect.
The scoring model is based on your potential to go 90 days late on an account within the next 2 years. Any recent late payments are a big reflection that the consumer will default, and their credit score plummets as a result.
2. 30% of the total FICO credit score is based on Available Credit, or the amount of credit available on open accounts. FICO credit scoring models rate credit scores higher if revolving accounts have balances less than 25% of the high credit limits. The utilization factor that affects the credit score does apply to most accounts credit cards, car loans, mortgages, and other accounts including installment loans.
This is why credit scores will go down when a new mortgage or car loan reports on the credit report. And as those accounts are paid lower each month, the scores steadily increase. For this reason it’s important for consumers know that a fast and easy way to increase their credit score, is for them to pay down the balances on their credit card accounts so the balances are lower than 25% of the limits while keeping a small running balance on all revolving credit card accounts. Or they can call creditors to ask for a credit increase which can also improve their utilization and scores.
3. Length of Credit History “Time in the bureau” accounts for 15% of the consumer credit score. The older consumers are and the longer they have had credit accounts for, the higher the score. This is why it is near impossible to get to an 800 score at a young age. As consumers have more accounts throughout their life, and history grows over time, their scores will naturally increase. Being added as an authorized user, to an account with a long pay history, is another way to increase consumer scores. But keep in mind, the new scoring models won’t give them credit for most authorized user accounts, unless they are family members of consumers.
4. Accumulation of new debt accounts for 10% of the total consumer credit score. This aspect of the credit score is comprised of how much new debt someone is applying for. It takes into consideration how many accounts a person currently has open, how long it has been since they opened a new account, and how many requests they have for new credit within a 12 month time period. If a consumer goes out today and applies for credit, that creditor requests information from the credit bureaus.
This counts as an inquiry on their report. If they have a lot of inquiries in a short period of time, their scores will be impacted. If a consumer applies for a mortgage today their scores might drop one point. But, if they apply for a car, a mortgage, and a few credit cards this week, their scores could drop significantly. Any large groupings of inquiries on a report can and will lower the credit score. So consumers should not not to apply for too much new credit in a short period.
Why Does Each Credit Report Vary by Credit Bureau?
When viewing your credit reports you will notice some accounts differ for each credit bureau. Some accounts will have different information between credit bureaus while others may not even appear on all three reports.
The reason reports differ is because each credit agency collects data independently. Some furnishers including smaller banks and debt collection agencies do not report to all three credit bureaus.
Public record information as bankruptcies, tax liens, garnishments, etc., is sometimes gathered by each credit bureau by sending a person down to the courthouses to fish through the records. When the bureaus use different people, they sometimes report the same public record information differently, causing additional variations among credit reports.
Yet another reason the credit reports differ is that the bureaus often receive and process information from furnishers at different times. In 2002, a study by Consumer Federation of America estimated that tens of millions of consumers are at risk of being penalized by inaccurate and inconsistent credit reports.
This is why it is always recommended you have send you a 3-in-1 credit report so that you can identify and correct negative items across all three bureaus.
Rights under the FDCPA
Here is a brief review of our rights under the FDCPA:
It details a person’s right to request more information about the alleged debt. The procedure is called debt validation and it’s a powerful intervention that we will be explaining in greater detail. Until then, understand that debt validation allows every consumer the right to dispute the validity of the debt. The collection agency must respond with proof that the debt belongs to the person, otherwise they must stop collection efforts and REMOVE the account from all credit reporting agencies. Debt validation is an effective tool for removing collection accounts.
Provides behavioral standards for acceptable third-party collections. The following are examples of violations:
The collection agency threatens to tell your client’s employer or neighbors about the debt, or actually does tell them about the debt.
The collection agency speaks about the debt to a party that is not responsible for the debt.
Pre-Texting- The collection agency acts as another company in an effort to gain additional information. Here is an example: the collection agent claims to be from a raffle/prize company and notifies the debtor that they “Won” in order to extract information about their finances, employment or other items.
The collection agency calls at unreasonable hours. 9:00 p.m. – 8:00 a.m. is considered unreasonable under the federal law.
The collection agency threatens to take action against the person that it cannot legally take (for example, threatening to take money out of their Social Security check or threatening arrest or jail).
The debt collector communicates with the person in a manner to harass, intimidate, threaten, or embarrass the debtor.
The debt collector communicates with the person or spouse more than three times in a single week.
The debt collector communicates with the person through the use of notices that look like government documents, or emergency messages.
The debt collector is prohibited from soliciting a postdated check in order to threaten criminal prosecution. A postdated check may not be deposited by a collector before the date on the check. Additionally, a collector’s acceptance of a postdated check violates the law unless it gave the consumer who wrote the check 3 to 10 business days notice prior to depositing the check.
Requires debt collectors to immediately identify themselves when communicating with the person whether it is on the telephone “Hi this is Joe from ABC collections” or in written form “This corresponded is an attempt to collect a debt.” This helps to prevent sneak attack behavior.
Allows a person to request that the collection agencies stop contact with them. This is formally called “cease and desist.” However, this is not recommended because the collector will have no other choice but to take the person to court. So be careful before you send any letter with the words cease and desist on it, as you might get your client sued.
The FCRA and Credit Reports
Check out some of the most favorable points of the Fair Credit Reporting Act (FCRA) that really help consumers.
Provides consumers with a free copy of their credit report once per year and ensures that they can purchase it at a fair price.
Regulates who has access to credit reports. The official term used in the FCRA is “Permissible Purpose” which means who is allowed to run someone’s credit report. An inquiry is mark made with someone runs the consumers credit report.
Details how long negative information can appear on a credit report. The FCRA spells out how long negative information, such as late payments, bankruptcies, tax liens, judgments, may stay on a consumer’s credit report.
Details how data furnishers must handle disputes.
It details that once negative information is removed as a result of a consumer’s dispute; it may not be reinserted without notifying the consumer in writing at least 5 days prior to re-insertion.
Allows consumers to challenge the information on their credit report on the basis of completeness and accuracy. If, after an investigation by the credit bureau, the disputed information is found to be inaccurate or can no longer be verified, the credit bureau must promptly remove the information.
What is the statute of limitations (SOL)?
A lot of people get the statute of limitations confused with the FCRA credit reporting time. While they’re both time limits related to debt, they have different effects.
The statute of limitations for collecting a debt is the period of time that a creditor or collector can obtain a judgment through the court system to force a person to pay for a debt. The time period starts on the account’s date of last activity (DOLA) and varies by state. Even if the statute of limitations has expired, some debt collectors will continue to attempt to collect. They’re hoping the person doesn’t know about the statute of limitations and will pay if they threaten enough.
Be careful to insure you don't restart their statute of limitations. Any time you take action with an account, the statute of limitations is restarted. Making a payment, making a promise of payment, entering a payment agreement, or making a charge using the account can restart the statute of limitations on an account. When the clock restarts, it restarts at zero, no matter how much time had elapsed before the last activity.
Keep in mind that when the statute of limitations expires, it only prevents a collector from winning a judgment against the person. It does not:
Erase the debt. If the debt is legitimate, the person will still owe it.
Prevent the debt from being reported on your credit report. The debt can be reported as long as the FCRA credit reporting time limit allows.
Stop all Harassing Collection Phone Calls
Many consumers are consistently harassed by debt collectors. With auto dialers, collectors can now have their computers call consumers multiple times per day. And this can continue 7 days per week for months.
It is actually very easy to stop these calls.
According to the Fair Debt Collection Practices Act (FDCPA) a debt collector is supposed to notify you a consumer in writing 30 days prior to them calling the consumer. When a letter is received from a debt collector the consumer should then mail back a cease and desist letter.
According to the FDCPA when the debt collector receives this letter they must stop calling or writing that consumer.
If calls have already started the consumer can obtain the debt collector’s name and send the cease and desist letter to stop future phone calls.
A C&D letter will stop almost all debt collector contact attempts.
But the FDCPA doesn’t apply to the original creditor, only the debt collector.
In Florida, Statute Fla. Stat. 559.55 -.785 Part VI, is an extension of the FDCPA and extends the reach of the law to include original creditors also. Check your own state laws as many states also have their own state FDCPA laws.
Here is a sample Cease and Desist letter you can use to stop illegal and harassing collection attempts:
Dear Debt Collector /Debt Collector Attorney:
This will serve as your legal notice under provisions of federal law, the Fair Debt Collection Practices Act (FDCPA), to cease all communication with me in regard to the debt referenced above. If you fail to heed this notice, I will file a formal complaint against you with the Federal Trade Commission who is responsible for enforcement, the States Attorney General office and/or the American Collectors Association or local State Bar Association.
I/We have decided that we do not desire to work with a collection agency under any circumstances. I/We will contact the original creditor to resolve this matter directly, as circumstances warrant.
You are also notified that should any adverse information be placed against my/our credit reports as a result of this notice that appropriate actions will be taken. Give this very important matter the attention it deserves.
Remember I am NOT an attorney and this does NOT serve as legal advice, only reference to a consumer law which might help you. You should also use a similar disclaimer.
What is the difference between a hard inquiry and a soft inquiry?
There are two types of inquiries on a credit report, often referred to as "hard" and "soft:"
Hard inquiries occur when a lender checks your credit report because of an application for goods or services, so they may affect your credit score.
Soft inquiries are usually initiated by others, like companies making promotional offers of credit or your lender conducting periodic reviews of your existing credit accounts. Soft inquiries also occur when you check your own credit report or when you use credit monitoring services from companies like Experian. These inquiries do not impact your credit score.
Also please add under that:
How many points does an inquiry drop your credit score?
According to FICO, a hard inquiry from a lender can decrease your credit score by five points or less. If you have a strong credit history and no other credit issues, you may find that your scores drop even less than that. The drop is temporary. Your scores will bounce back up again, usually within a few months, assuming everything else in your credit history remains positive.
When you request a credit limit increase, is that a hard inquiry too?
Possibly. It depends on the lender and their policy for how they treat that request. Some lenders may treat it as an application for new credit or additional credit and require a new credit report to be accessed, which will then display as a hard inquiry. Others may approve the request without pulling your credit report or by doing what's called an "account review," which will appear on your report as a soft inquiry. If you are concerned, it's best to ask your lender before applying for a higher credit limit
What about when you are shopping for a loan?
When you are shopping for a new loan, such as for a home or a car, your information may be sent to multiple lenders to try to find you the best rates and loan terms. You will see a separate inquiry on your credit report from each of these lenders, but your credit score won't be penalized for each one. Most credit scores will count multiple inquires for mortgage or auto loans as one if they are made within a certain period of time (14-30 days). Some scores do the same for other types of lending