Credit scoring is a complex issue
It is much more than just deciding what is a good or bad score. It is about deciding what is a legitimate score (or score that is not valid) and which are “good” and “bad” credit scores. Because there are so many ways to create a credit score, credit scores can range from no score at all to triple AAA. This is the exact reason why being a credit expert and a savvy consumer is so important. In many ways, it is like purchasing a home. There are so many things to think about and consider when choosing a home. The right credit score can be the difference between a decent (aka first-time homebuyer) home loan that will be reasonable or a first-time homebuyer that will need a mortgage or a special payment for 20 years. How can you work to improve your credit score?
What is credit scoring?
Credit scoring is the process by which banks, lenders, other creditors, and others assess and judge the creditworthiness of an individual or business by analyzing a consumer’s payment behavior, available credit, debt levels, income, employment, and other credit factors. So why is there so much confusion about how credit scoring works? Because the current model for determining creditworthiness and credit scoring is not only antiquated but creating serious problems with today’s mortgage landscape. The only information lenders can use for determining creditworthiness is the data they already have and what these lenders base their decisions on is personal information.
How does it work?
As I have previously explained, credit scoring is a system that combines data from many different sources to get a picture of your creditworthiness. The first sources to be looked at are any mortgages you may have taken out, such as home equity lines or mortgages with credit lines. Then, additional data is added from credit cards, mortgages, and accounts that have been reported to either the credit bureaus or a secondary source, such as Equifax. As you can see, credit card activity makes up over 60% of your credit score. Once you have added any credit sources to the mix, an algorithm is run to analyze what type of risk you represent. Then, the score is a collection of all these various factors, which get added together.
Why is credit scoring so important?
The most basic way to put it is simply the fact that without a credit score, you cannot borrow money. Or as I like to put it, without credit you don’t exist. Credit scores are used by lenders and loan servicers, businesses, and financial institutions to determine your creditworthiness, with the most common score being the FICO score. You can apply for a mortgage, loan, or credit card but you don’t get a loan until you get a credit score. If you want to get a credit card, you have to have a credit score. If you want to get a mortgage, you have to have a credit score. Even if you are in line to purchase an item at a store like Walmart, you must be given a credit score, and the items have to be sold by a store like Walmart, you will be sold only if you have a credit score.
A more modern model
In my previous post I explored how a new credit scoring model would look like. It’s interesting to observe that the current models are nothing more than rebrandings of the same models I covered in the previous post. A few minor tweaks, the model could be called the Equifax Zest Score™ (an acronym), the Equifax Median Score™ (MD Score), the TransUnion Full Score™, etc. It’s basically the same system but the name of the model is a bit different. What we are left with is a credit scoring system that has been in use for decades now and there is still no consensus on the score that it should ultimately be called. If you want to know more about what a credit scoring model is, you can read the U.S.
In the worst case, an individual could find himself or herself without a place to live, unable to afford his or her mortgage, having difficulty affording his or her bills, or even being considered a credit risk. As Dr. Suzanne Mintz points out in “Risks to the Post-Crisis Financial Crisis,” given the various economic and political challenges facing the U.S., the prospects for the current credit scoring system to continue to provide the most accurate scores necessary to accurately assess a consumer’s risk of default remains highly questionable.