Credit scoring models
Although various methods of estimating credit worthiness existed before, modern credit scoring models date to 1956, when Bill Fair and Earl Isaac create their first credit scoring system.
The FICO score was first introduced in 1989 by FICO, then called Fair, Isaac, and Company. The FICO model is used by the vast majority of banks and credit grantors, and is based on consumer credit files of the three national credit bureaus: Experian, Equifax, and TransUnion. Because a consumer’s credit file may contain different information at each of the bureaus, FICO scores can vary depending on which bureau provides the information to FICO to generate the 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 formulas for calculating credit scores are secret, FICO has disclosed the following components:
Payment history (35%): Best described as the presence or lack of derogatory information. Bankruptcy, liens, judgments, settlements, charge offs, repossessions, foreclosures, and late payments can cause a FICO score to drop.
Debt burden (30%): This category considers a number of debt specific measurements. According to FICO there are six different metrics in the debt category including the debt to limit ratio, number of accounts with balances, the amount owed across different types of accounts, and the amount paid down on installment loans.
Length of credit history or “time in file” (15%): As a credit history ages it can have a positive impact on its FICO score. There are two metrics in this category: the average age of the accounts on a report and the age of the oldest account.
Types of credit used (10%): Consumers can benefit by having a history of managing different types of credit. Examples of types of credit include installment, revolving, consumer finance, and mortgage.
Recent searches for credit (10%): hard credit inquiries or “hard pulls”, which occur when consumers apply for a credit card or loan (revolving or otherwise), can hurt scores, especially if done in great numbers. Individuals who are “rate shopping” for a mortgage, auto loan, or student loan over a short period (two weeks or 45 days, depending on the generation of FICO score used) will likely not experience a meaningful decrease in their scores as a result of these types of inquiries, as the FICO scoring model considers all of those types of hard inquiries that occur within 14 or 45 days of each other as only one. Further, mortgage, auto, and student loan inquiries do not count at all in a FICO score if they are less than 30 days old. While all credit inquiries are recorded and displayed on personal credit reports for two years, they have no effect after the first year because FICO’s scoring system ignores them after 12 months. Credit inquiries that were made by the consumer (such as pulling a credit report for personal use), by an employer (for employee verification), or by companies initiating pre-screened offers of credit or insurance do not have any impact on a credit score: these are called “soft inquiries” or “soft pulls”, and do not appear on a credit report used by lenders, only on personal reports. Soft inquires are not considered by credit scoring systems.
These percentages are based on the importance of the five categories for the general population. For particular groups—for example, people who have not been using credit long—the relative importance of these categories may be different.
The makeup factors are limited to the individual’s past (and continuing) behavior on credit. Contrary to common misconception, other financial factors such as age, employment status, assets, or income are not accounted. However, lenders are not prohibited from asking about and accounting these factors for particular lending considerations.
Getting a higher credit limit can help a credit score. The higher the credit limit on the credit card, the lower the utilization ratio average for all of a borrower’s credit card accounts. The utilization ratio is the amount owed divided by the amount extended by the creditor and the lower it is the better a FICO rating, in general. So if a person has one credit card with a used balance of $500 and a limit of $1,000 as well as another with a used balance of $700 and $2,000 limit, the average ratio is 40 percent ($1,200 total used divided by $3,000 total limits). If the first credit card company raises the limit to $2,000, the ratio lowers to 30 percent, which could boost the FICO rating.
There are other special factors that can weigh on the FICO score.