Prior to today's credit rating systems, lenders had to carefully examine every applicant's details, in the hopes of finding some clue as to whether the person was likely to repay the loan, or default on it.
The whole thing was not only very time consuming and cumbersome, but also very hit and miss, and as the size of the loan companies grew, so did the number of loan requests, and it became increasingly difficult to successfully monitor so many applications.
A system was therefore needed that would allow a person's credit score to be reduced to a single number, thereby providing a standardized way of computing the risk that a borrower posed.
The first credit rating system to be almost universally accepted was Fair Isaac, and although many others have since emerged, it still remains the most popular, and all the present systems basically rate a person's credit score between 350 at the low end to 850 at the high end.
None of the systems are anywhere close to perfect, because not all lenders report to all the credit companies, and even the three major credit bureaus, Equifax, Experian and TransUnion will most likely report different credit scores for the same person.
The higher your credit score the better, and if you have one that's close to the high-end then you can buy a Mercedes just by signing on the dotted line, whereas one close to the bottom probably means that you have debt collectors knocking on your door.
All the available ratings systems are more similar than different, so let's look at the FICO one in detail, because it's the most popular.
Five separate factors are considered, and each one is weighted somewhat differently.
Payment History = 35%
a) Borrowers who are current on their accounts are generally assigned a lower default risk.
b) Delinquencies, late payments, collection actions and bankruptcies will all have a major negative impact on your score, and the more recent the delinquency is, the larger the negative impact.
Amount Owed = 30%
a) This factors in your overall debt levels, on auto and home loans as well as how close your credit card balances are to the credit limit. How much of your credit line you're using is also factored in, and the figure is arrived at by dividing your total credit line by your total credit card balances. The bigger the number is, the higher the risk you're thought to be. A figure of around 25% usage is optimal.
Length Of Credit History = 15%
a) If you have a short credit history, then less is known about your safety and therefore creditors conservatively rate you as a higher risk. Longer is better.
New Credit = 10%
a) Every time you open a new account, you're considered to have taken on new debt obligations. It's a negative sign, and it sends out a signal that maybe you can't cope without more credit.
b) They're considered as soft inquiries, which means that they came from either current lenders who are simply evaluating your credit, landlords, pre-approved offers, or from you, yourself. Soft enquires don't affect your credit score one way or another.
c) An application for new credit shows up as a hard inquiry on your credit report and suggests that you might be taking on more debt than you can possibly handle.
Types Of Credit Used = 10%
a) Store credit cars are correlated to higher default risk, and they negatively impact your credit score, whereas having a mix of different types of credit such as credit cards, auto loans, and a mortgage will have a positive effect.
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The author of this article was a film producer, and award winning film sound editor for many years. He has a major interest and flare for economics, and one of his websites ->
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