Minnesota Attorney General's Office
1400 Bremer Tower
445 Minnesota Street
St. Paul, MN 55101
M - F 8 am - 5 pm
Credit scores are used by credit card companies, auto lenders, landlords, and home mortgage lenders to predict the likelihood that a consumer will pay their bills. They are also used by insurance companies to decide how much to charge people for homeowners and automobile insurance and by some employers. A credit score is different than a credit report, which contains credit account details. Credit scores are prepared by different national credit bureaus. These companies each have their own database on consumers and convert their data into a credit scoring system, which has a range that varies from a low of 300 points to a high of 990 points. A higher score means the consumer has better credit capacity. A lower score increases the likelihood of being denied credit or that the consumer will pay more for it. A common practice by lenders, known as risk-based pricing, is to impose higher interest rates on consumers with lower credit scores.
Lenders and insurance companies use credit scores because they are inexpensive to purchase and easy to interpret. Credit scores have been criticized, however, because they can be gamed. According to one study, the predictability of credit scores has been reduced in recent years. In 2001, there was an average 31 point difference in the credit score of borrowers who defaulted on a loan and those who paid on time. By 2006, the difference was reportedly only 10 points. Credit scores are not only used by lenders. Landlords, employers, utility companies and insurance companies also use a variation of the credit score in determining whether to rent an apartment, give a job, underwrite an insurance policy, or hook up electricity.
The credit bureaus keep secret the exact formulas they use to calculate a person’s credit score. The industry, however, has launched an educational website, www.scoreinfo.org, that explains the factors that influence a credit score. According to the website, approximately one third of the credit score is based on timely payments to credit card companies, auto lenders and home mortgage companies. For example, if a defaulted account is reported to an individual’s credit file, 70 – 120 points are subtracted from the score. Another 30% of the score is based on the ratio of the consumer’s entire debt to the total debt limit available to the consumer. In other words, a credit score improves if the consumer pays off debt and has higher but unused credit available. A consumer who has a credit card balance of $3,500 on a credit card that has a limit of $5,000 is using 70% revolving credit capacity. This reflects more poorly than having a balance of $1,000 with a credit card limit of $5,000, which means the consumer is using 20 percent of credit capacity. Approximately one tenth of the score is based on the length of the credit history. The longer the consumer’s credit history, the higher the score, with a 20 year history being the most advantageous. Another ten percent of the score is based on the type of credit: the more varied the credit—such as installment, revolving, mortgage or consumer finance—the more likely that the consumer is deemed to be able to manage debt. Finally, another 10 percent is affected by recent inquiries on the consumer’s credit. This means the credit score drops if numerous inquiries from different creditors have been made. In addition to a credit score, banks and credit card issuers have been considering imposing other behavioral patterns before granting loans, such as checking account management, employment history, and property values.
A credit score can be diminished by several factors. Credit scores are negatively affected by bankruptcy, short sales, missing payments, late payments, closed credit cards, too much credit, maxed out credit limits, lack of variation in types of credit, and referral of accounts to collection agencies. For the most part, negative marks remain on a credit report, and therefore affect a credit score, for seven years. This is true except for a bankruptcy, which remains for ten years. There are several things consumers can do to improve their credit scores. When you receive your credit score, examine the “reason codes” that state the grounds why a score is not higher. To boost a credit score:
- pay your bills on time
- become current and stay current on any missed payments
- talk with your creditors about reducing your monthly payments
- do not open a lot of new accounts rapidly only open new accounts as needed
- keep balances low - below 25 percent of the credit limit on credit cards and other “revolving credit”
- pay off debt rather than moving it around
Also, remember that:
- A long credit history is important, so use old credit cards to pay for small purchases or for a recurring bill.
- Ask a lender to “re-age” a troubled account, which means, if the account is still open, to erase prior late payment records if you make a series of a year or so of on-time payments.
- When deciding to make a big purchase and buying a credit score, ask the lender for the name of the credit score that will be used to evaluate your creditworthiness.
- Dispute old debts with the credit bureaus.
- Routinely check the accuracy of your credit reports at the three main credit bureaus and correct any errors that may be found.
- The worst approach is to ignore credit problems, because they will not go away.
While credit scores can be improved, it is important not to use “credit repair” companies. These companies offer to improve your credit score or lower your interest rates for a fee. Unfortunately, these companies hardly ever improve a consumer’s creditworthiness. Two organizations that can assist you in locating a reputable nonprofit credit counseling agency are the Lutheran Social Services Financial Counseling Service and the National Foundation for Credit Counseling. You may contact these organizations as follows:
Lutheran Social Services Financial Counseling
424 West Superior Street, Suite 600
Duluth, MN 55802
(888) 577-2227 or (218) 529-2227
National Foundation for Credit Counseling
The Fair and Accurate Credit Transactions Act of 2003 requires credit bureaus to give consumers a free annual report. You can obtain your free credit report at www.annualcreditreport.com. Effective January 1, 2011, lenders who charges a borrower a high interest rate on a loan have to give to the borrower a “risk based” pricing notice or, in the alternative, a copy of the applicant’s credit score together with a graphic illustration comparing the applicant’s credit score with other consumers. Effective July 21, 2011, lenders must give a free credit score to any borrower who is charged a higher interest rate or turned down for a loan. This “adverse action” requirement will also apply to landlords, utilities and insurance companies who use the score.
You can find more information about how to receive copies of your credit report by reviewing another publication distributed by the Attorney General’s Office entitled: Have You Checked Your Credit Report Lately?