Sunday, April 23, 2006

New credit scores supposed to help lenders facilitate loan pricing

Just when you thought that you were beyond the problem of needing to achieve higher letter grades for your “permanent” record, here they come again! Yes, now you will have the pleasure of being “letter graded” from cradle to grave.

A new credit scoring system is being introduced that reduces the previous FICO number to an alternative letter grade (A, B, C, D, F) — or VantageScore(SM). In a time when interest rates seem to have an upward trend, the higher our credit score (no matter which method is used), the more justification we have to argue for lower interest rates and higher loan amounts from lenders. This article discusses the new system and how it relates to the more-established FICO score.

The goal of all credit scores is actually to facilitate loan pricing and securitization for lenders that do not retain credit exposure on their loans. Defaults on loans create losses that are spread across all loans, so we all benefit from low default rates. Those with poor credit do not usually qualify for much credit and the interest rate they pay is usually higher than the rate paid by those with top credit ratings. Many studies exist showing a high degree of correlation between default rates and credit scores. This is not always true in individual cases because some borrowers are better at negotiating both loan amounts and interest rates with various lenders.
The three major credit bureaus (Equifax, Experian and Trans Union) currently emphasize the Fair Isaac Corporations FICO score to establish our credit status. If you have used these agencies, you have probably noticed that they do not produce the same score/number.
The key FICO factors are: (1) Payment History — about 35 percent, (2) Amounts you owe — about 30 percent, (3) Time you have had an established credit history — about 15 percent, (4) Types of credit you have used — about 10 percent and (5) History of attempts to establish additional credit — about 10 percent.

Note that the score calculation only considers items on your credit report whereas lenders look at other factors such as employment history, level of income and type of credit you are seeking. Everyone should keep informed about their credit reports and seek to remove incorrect information as soon as possible. Improvements in FICO scores can be achieved over time by (1) avoiding late payments/collections activities, (2) reducing credit card balances (canceling them can have a negative impact), (3) avoiding too many applications for credit while maintaining sufficient credit for your needs.

FICO scores range between about 300 and 900. The median FICO score is around 720; scores above 725 are considered “good” while scores below 600 are considered “bad.” In theory, the higher the number, the greater the amount of credit you can obtain and the lower the interest rate. Report any credit report errors to all three credit agencies: U.S., Equifax (1-800-685-1111), Trans Union (1-800-916-8800) and Experian (1-888-397-3742). These agencies have procedures in place to help you maintain an accurate report.

Note that in the list of key factors, your credit history and the amount of time credit has been established play a significant part (approximately 50 percent) in the calculation of the FICO score and employment history is a part of the lender’s decision. What if you are essentially “new” to the work force and you have not established a credit/payment history? One criticism of the FICO score is that it does not provide for those that are beginning the long road of credit management. It is anticipated that the new VantageScore system will provide more support for those in this situation.

Introduced in March jointly by the top three credit rating agencies (patent pending), VantageScore(SM) is not expected to have an immediate impact on credit decisions. In time it will become the first rating system that applies consistent analysis across all three companies. This will reduce differences in ratings between agencies to differences in data files rather than model interpretations of data. Since it was developed using the credit histories of approximately 15 million consumers, it provides for those that are new to obtaining/managing debt, improving the chances of obtaining debt at lower costs. Letter grades for the VantageScore system are produced as follows: A901-900, B801-900, C701-800, D601-700 and F501-600.

As we manage the quantity and cost of debt over time, this new system will probably become another factor used by lenders.

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