How Credit Scores Work and Why They Matter Now More than Ever

Like it or not, a credit score is the language of lending approval for the consumer and for small businesses. It provides a standardized way that lenders can quickly evaluate and filter out loan applicants for all types of credit products ranging from revolving lines of credit to mortgages, and its not going away any time soon. In fact, credit scores are now expanding in their use beyond just financial tools as well. Here's an introduction to get you familiar with the concept.

Background

For decades, credit scores have followed the FICO model, a mathematical model developed by the Fair Isaac Corporation. The formula gives different points to different types of loans based on a variety of factors, including how they have been handled by the consumer, the rate of successful payment, the age of the loan, the amount of credit still available from existing lenders, and other negative factors such as foreclosure or bankruptcy if present. All of these elements add up to a total which represent a person’s raw credit score. Lenders then decide which point level is desired, which is acceptable, and which “don’t make the cut” and should be rejected.

Use and Application

Credit scores have long been used to evaluate borrowers in a way that provides a solid defense against accusations of discrimination. Instead of having to prove the bank did it’s research to objectively provide loans, lenders can simply sit back and put the burden on the consumer for not keeping his score high enough.

However, credit scores are now being found elsewhere as well. Because a the score is a symbol of a person’s ability to manage his finances, which requires discipline and often leads to financial success, people are beginning to put weight on scores as a way to evaluate someone's character, especially when deciding if a person should be trusted with responsibility. Areas where credit scores are being seen as a gauge include:

• Rentals and leases – Landlords and property management companies frequently believe there’s a direct correlation between a credit score and how reliable a tenant will be in paying rent timely. As a result, scores are often being used for tenancy approvals.

• Security clearances – Those who can’t manage their finances well can be seen as a potential risk for blackmailing and temptation to disclose data or products for easy money.

• Hiring – Companies have long known application forms and interviews don’t tell very much about a job candidate. However, credit scores can often signal a disciplined, reliable person versus a poor candidate that shouldn’t be hired.

Improving a Personal Score

The best ways to improve a personal credit score are usually controllable. They involve making debt payments in a timely manner or, even better, paying off debt completely. Multiple accounts should also be streamlined to the oldest, largest accounts, with a preference for collateralized debt versus open-ended revolving lines of credit (i.e. credit cards). This shows long-term stability and successful debt management, which scores better. Consumers should also regularly vet their credit history to find and remove any mistakes which can negatively score downward.

A credit score doesn't have to be a thing feared, but it does take work to maintain and monitor. A consumer who understands this fact gains an upper hand on the scoring system, understanding how to use it.