One of the most popular definitions of the same is that it is the numerical equivalent of a consumer’s status as a financial boon or risk. Payment on time and in full, coupled by responsible use of various credit instruments adds points. Defaults, irresponsible use of credit, or limited utilization means negative points. Sort of a report card of how well a consumer has been handling his/her finances. The same maybe accurate, but it is an oversimplification of the concept. Below is a more detailed discussion of the same.
3 Important Aspects of the Computation
The first is information. This is either reported by creditors, like entities or investigated by credit reporting bureaus. The second is the positive and negative points that it is assigned to. The third is the trickiest. It comprises of a formula that determines the weight each piece of information is given. The same formula is a well kept secret. All three combined will yield a credit score.
Reports Computations Scores
There are three credit bureaus that are considered the best. These are Equifax, Experian and TransUnion. However there are dozens, if not hundreds of other reporting bureaus, each with their own report, formula and score.
As a general rule most credit bureaus based their computation on the FICO scoring model. FICO stands for Fair Isaacs Corporation, and is arguably the most respected scoring model. FICO utilizes 5 sub categories.
This usually comprises 35% to 40% (35% FICO) of the credit score. There are three things to consider: How recent is the default; how many are the defaults, and; How severe is the default in payment.
Amount of Debt
This usually comprises 25% to 35% (30% FICO) of the credit score. This means any debt, revolving debt, credit card debt, etc. It is worth noting that credit card limit utilization plays an important part in scoring. The best utilization ratio per card is around 10% to 30% max.
This usually comprises 10% to 20% (15% FICO) of the credit score. How long has the consumer been using credit? What is the longest account? What is the average length of the account, etc. These are all considered in the computation.
Types of Credit Utilized?
This comprises 5% to 15% (10% FICO) of a credit score. The credit bureau, banks and/or lenders are looking for a consumer who has several different account types and credit utilization types. For example, a checking account, savings account, debit card, credit card, auto loan, home loan, insurance, etc. All of which are balanced and within the financial capacity of the consumer.
Last Credit Application
This also comprises around 5% to 15% (10% FICO) of the credit score. This is sometimes referred to as credit inquiries because application of credit usually entails hard inquiries. Consumers can shop around for credit or a loan, but it has to be a short sudden spurt, not a regular thing, and several at once.
There are other factors that credit bureaus consider i.e. credit readily available on short notice. It is also important to note, that most credit bureaus or at least banks and lenders put more weight on recent information and less weight on older information. That being said, the information then goes thru the secret computation or formula, then comes out as a score.