#2 – Understand Where Credit Scores Come From.

If you are going to raise your credit score, you must first understand what your credit score is, where it comes from, and how it works.

Your credit score is based on your credit report, which contains a history of your past debts and repayments. Credit bureaus use computers and mathematical calculations to arrive at a credit score from the information contained in your credit report.

Each credit bureau uses a different mathematical model to do this but all the credit bureaus use a model similar in concept at least to the FICO system. FICO is an acronym for the credit score calculating software invented by Fair Isaac Corporation. The Fair Isaac Corporation developed the FICO system in 1958 as the first widely used credit score model and is still considered by many in the financial industry as the leader in the field.

Credit scores are commonly called FICO scores or FICO ratings, although a prospective lender may use a credit score tabulated by a credit bureau using a different mathematical model.

FICO and other credit scoring software use different scoring methods to rate a borrower’s suitability for three types of credit- mortgages, automobile loans, and consumer credit- reflecting the loan default risks inherent to these different types of lending. It is not unusual for these scores to differ-by 50 points or more-for the same borrower.
A Credit Score is All Statistics and Mathematics

One other thing about the software and mathematics that makes your credit score is the fact that the algorithm is based on statistical sampling and comparative mathematics. This is an important and simple concept that can help you understand how to boost your credit score. In simple terms, what this means is that your credit score is calculated on the same principles as your insurance premiums.

Your insurance company asks you questions about your personal health, your immediate family’s medical history, and your lifestyle choices (such as whether you are a smoker) because these bits of information can be statistically sampled to tell the insurance company how likely somebody with a similar profile has been to make claims.

Studies have shown, for example, that smokers tend to be more prone to serious illnesses and so require more medical attention. If you are a smoker, you almost always pay higher insurance premiums than non-smokers regardless of your actual health.
Why Understanding How Credit Scores Work Can Help You

Similarly, credit bureaus and the lenders who use the information provided by the credit bureaus look at these same kinds of statistically significant patterns. Since people with a high ratio of debt to available credit tend to have lower rates of timely repayment, your credit score will suffer if you have too much debt. For example, if your credit report shows that you have $10,000 in unsecured credit and you have already used $9,000 of it your credit score will be lower than it would be if the ratio of debt to available credit were in the 10% – 30% range.

Understanding how credit scores work can help you in two ways:

1) It will let you see that your credit score is not a personal reflection of how “good” or “bad” you are with money. Rather, it is a reflection of how lenders and other credit score users think you will meet your financial obligations – all based on information mathematically derived from the behavior of large numbers of other people.

2) You can see that if you want to improve your credit score, you need to work on becoming the sort of debtor that studies have shown tends to repay on time. You do not have to reinvent yourself financially and you do not have to start making more money. You just need to be a statistically reliable borrower. You already know one way – a lower debt to available credit ratio increases your credit score. Realizing that your credit score is only a mathematical computation that can be changed by changing the value of the input variables should help make credit repair less personal and far less stressful!
How the Information in Your Credit Report Gets in Your Credit Report?

Credit reports are put together by credit bureaus, which use information they receive from their client companies. It works like this: credit bureau clients – such as banks, credit card companies and utility companies, to name just a few – provide them with information about the amount of credit they have made available to you and how timely you have been in repaying it.

Once a file on you is started, by you opening a bank account or buying something on installment, then information about those transactions is passed on to the credit bureaus and stored in a database. If you are late paying a bill, the clients notify the credit bureaus that make an appropriate entry in their databases. Most all communications of this nature are done with two and three digit numeric codes. This data entry method may work best for databases containing billions of records, but is a method nonetheless that is ripe for creating and perpetuating errors. Reliable sources say that 79% of all credit reports contain errors and that at least 10% of all credit scores are wildly inaccurate.

Your age, sex, and income do not count towards your credit score. The actual formula used by credit bureaus to calculate credit scores is a well-kept secret, but it is known that recent account activity, debts, length of credit, unpaid accounts, and types of credit are among the things that count the most in tabulating credit scores from a credit report.

In #3 we will cover the individual components of a credit report in more detail and reveal the best estimate of how much a change in any individual component can affect your overall credit score. Once you have a handle on this critical information you will begin to see the kinds of things you can do to make yourself a statistically more reliable borrower – with a higher credit score.