How Does Your Credit Score

In a recent publication the FDIC explained how banks and other lenders use automated "credit scoring" systems to determine how good or bad a risk a person is. The better a person's credit score, the more favorable the terms of a loan or credit card.

One way lenders quickly evaluate thousands (and sometimes millions) of loan applications is by using automated "credit scoring." Even if you have no plans to apply for a new loan soon, we think you should know about credit scoring. Why?

Because the next time you do want a mortgage, car loan, credit card or other type of loan, your credit score could affect the interest rate you are charged. It could determine the repayment terms and other conditions of the loan. Your credit score could even play a role in whether you are approved for the loan. To be on the winning side of this scoring system, it helps to know the basics.

What Is Credit Scoring?

Credit scoring is a tool that's designed to enhance a lender's ability to determine the likelihood that a consumer will repay a loan. It's based in part on credit scoring "models," which are computerized systems that look at a variety of factors (sometimes hundreds) relating to many consumers' credit histories and personal information, such as age, income and level of outstanding debt.

Scoring systems collect this data to try to predict a consumer's willingness and ability to pay future debts. Credit scoring systems usually produce a numerical score--a credit score. Lenders use these scores as tools to help decide if a loan should be made and to set repayment terms.

If a Credit Score Is Low

A credit score in the lower ranges doesn't automatically disqualify you from getting a loan. But it may prompt the lender to review your qualifications more carefully before deciding whether to approve or deny the loan. Or, a low credit score may result in a higher interest rate or more stringent repayment terms than those offered to other consumers.

If a lender's scoring system is properly designed, tested and monitored, it should give a faster and more impartial evaluation of creditworthiness than a loan officer could have made on his or her own.

A credit score, however, can be an imperfect way to try to predict whether someone will default on a loan. Among the reasons: the information that was reported to the company that developed the scoring model (perhaps a credit bureau) may be inaccurate or the statistical assumptions behind the program may be unsound.

Credit scores generally are not released to consumers. But under the Fair Credit Reporting Act, if you are rejected for a loan because of inaccurate information in a credit report, you have a right to get a free copy of that credit report and to have mistakes corrected. Catching and correcting any mistakes may have a positive effect on your credit score and 'could improve the chances that your loan will be approved.

Improving Your Score

Just like building your own credit history takes time, it also takes time to significantly improve your credit score. ... and your chances of getting a loan at favorable terms. According to a consumer brochure published by the Federal Trade Commission (FTC), you can boost a low credit score by "concentrating on paying your bills on time, paying down outstanding balances, and not taking on new debt." ( What's the Score on Your Credit?, FDIC Consumer News [Summer 1999])

It makes sense if you are applying for a loan or a new credit card to ensure that your credit history report is accurate. This can be done by contacting each of the major credit bureaus and asking them for a copy of the file. In fact, issuers that deny a person a credit card must supply the name, address, and telephone number of the credit bureau that produced negative information. You can contact the company within 60 days and receive a free copy of the credit report. If there's a mistake, contact the creditor and work it out. If a credit history shows one delinquent bill among a variety of good credit transactions, you should try to work it out immediately. Perhaps that bill got lost in the shuffle of moving, or old roommates didn't forward that piece of mail. Once the outstanding balance is paid, make sure the blemish is corrected on the credit report. If the credit report shows multiple incidents of delinquent payment or nonpayment, you will have to start paying much closer attention to your financial dealings. It will take time--and an excellent payment record--for creditors to conclude that you have really changed your ways. Negative comments stay on the creditor's file for seven years. A bankruptcy filing can stay on a credit history for 10 years.

For young people who have not yet established credit, it's better to start small. Apply for a gas credit card or a department store credit card. Use it sparingly and pay off the entire balance each time the bill arrives. Ask the issuer if it reports to one of the credit repositories so that there will be a record of your credit and good payment history.

Another way to establish good credit is to ask someone with a good credit history to become a co-signer. For example, a student going to college may ask one of her parents to become her co-signer. This way, the student who makes regular payments establishes good credit and the card issuer takes on little risk because the co-signer is responsible for the payments if the student doesn't make them. Such nonpayment can obviously lead to resentment and strained relationships.

If there is no relative or friend able to serve as co-signer, and no other way to establish credit, you can ask for a secured credit card. The issuer will require that you put some money in an account, and any purchases or transactions charged on the credit card come out of this reserve. It"s more limiting because you can only spend a portion of the money and because the interest rates on these cards are generally higher. But by using this card smartly--making small purchases and promptly paying off the balance--and by making sure that these transactions are reported to credit repositories, you can improve your credit risk and soon apply for more advantageous credit cards.

The terms of credit cards for people with no credit history can be unattractive. For example, one recent credit card offer sent by a major national bank to someone with no credit history at all offered a $500 limit in unsecured credit, with a 23.99% APR and a one-time processing fee of $89 and an annual fee of $59 billed on the first statement. There was no grace period on purchases and a 5% transaction fee for cash advances. While accounts are reviewed every three months to determine whether the credit line is increased, the card issuer noted that it might levy a fee to increase the credit line. During this same period, people with good credit ratings were receiving offers with APRs in the single digits or low teens and no associated fees. Going with a major national credit card can be an expensive way to establish credit. Gasoline and department store credit cards, on the other hand, often require no fees and help the account holder establish some credit history.

Establishing good credit is useful for more than applying for credit cards, of course. People with the best credit receive the best terms on auto loans, home loans, and other major loans. Some employers check credit history before hiring an employee, and many landlords will check someone's credit history before renting a house or apartment to them.

Once you have decided to obtain a credit card, don't sign on the first offer received. Fees, charges, and benefits vary greatly among credit card issuers. Here's what to look for.

Annual Percentage Rate (APR): just as banks and credit unions pay interest to bankers or investors, credit card holders pay interest to credit card issuers. The APR is stated as a yearly interest rate. It's also important to note the "periodic rate"--the rate the issuer applies to any outstanding balance to figure the finance charge for each billing period. The finance charge is the amount of interest charged to the bill each month. A zero balance, of course, doesn't accrue any interest charge. The lower the interest rate, the better.

Grace Period: This is the period between the day a credit card holder purchased something and the day the credit card company begins charging interest. If a card has a grace period of nearly a month, the credit card holder can avoid paying any interest if balances are paid off in full each month. Some credit card companies will allow a grace period for new purchases, even if the old balance isn't paid. In other words, the holder still pays the finance charge on the outstanding balance, but interest isn't calculated on purchases made that month. Others provide a grace period only for zero balance accounts. In that case, if there is an outstanding balance and new purchases are made that month, the following bill will reflect finance charges on the old balance and the new purchases. And some credit card companies provide no grace period, meaning that interest is charged on each transaction beginning the day it was made. The longer the grace period, the better.

Annual Fees: Some issuers charge no annual fee, but many credit card companies charge an annual fee, typically ranging from $15 to $55.

Credit Limit: The applicant"s credit history and current income will help determine the credit limit--the amount the issuer will allow the holder to charge. It might be less than what is offered in an invitation letter. For young people just starting to establish credit, the limit can be fairly low. However, credit card companies will often increase the limit as the holder demonstrates good payment habits. As a customer service, a card issuer might agree to raise the credit limit in an emergency or at the request of the holder.

Other Charges: Some credit card issuers charge a flat fee, whether the card is used that month or not. Others charge transaction fees if the card is used to obtain a cash advance, if the payment is late, or if the holder has exceeded the credit limit.

For those who do not pay off their balance in full each month--for example someone who is using the credit card to finance a major purchase-the APR becomes the most important-and potentially costly-part of the puzzle. Look again at the earlier example of Sue and Bill. Bill pays no interest for his vacation because he had zero balance on his credit card and pays off the $29 charge as soon as the bill arrives. His credit card issuer allows a grace period, so his bill will reflect no finance charges.

Sue had an outstanding balance of $150 and added $464 during the trip, leaving her to pay off more than $600. If she does so only by paying the minimum balance due, say $40 a month, it would take her about a year and a half. All the while, she's paying an 18.5% annual percentage rate. What should be of greater concern is that Sue hasn't shown a solid understanding of her finances. Chances are that during the time she's paying off this balance, she will continue to put other charges on her account, deepening the financial hole she's in.

Credit card issuers make their money through the interest they charge. Typically, the issuer will allow a holder to pay a "minimum monthly payment," a small percentage of the outstanding balance. As long as those monthly payments are made, the credit card issuer is willing to let the person keep paying off the debt in small chunks. That's because the issuer will continue to collect interest. For example, someone with a $2,000 balance could pay the minimum monthly payments and extend the debt for about 11 years. In that time, the interest charged to that $2,000 purchase would be $1,934, nearly double the amount.

What's worse is that debt tends to snowball. If someone is only making minimum payments, it's probably because he or she cannot afford any more. And then the temptation to use the credit card for other purchases becomes even greater. The outstanding balance grows; the finance charges grow. When it gets to the point that minimum monthly payments are only covering finance charges and not actually paying down any debt, the credit card holder is in serious financial trouble.

That apparently happens fairly regularly. Young people seem to be particularly susceptible to the lures of a credit card. In "Credit Cards on Campus: Costs and Consequences of Student Debt" ( June 1999), Robert Manning noted that it would be helpful if credit card issuers and college administrators took more responsibility to see that college students, often taking those tentative steps toward financial independence, didn't end up deep in credit card debt. His report suggested that issuers limit the total revolving credit extended to individual students to no more than 20% of their incomes. Other recommendations were that college administrators should not accept subsidies from issuers, should severely restrict credit card marketing on campus, and should insist that issuers provide more financial education for students, particularly during freshman orientation.

Source: Teen Guide to Personal Financial Management