It seems to many today that you could be John Dillinger in your lifestyle and get anything you want on credit so long as you have a high enough credit score. How did that come to be?
In previous decades, Creditors had a very sensible lending evaluation approach that employed 4 basic common sense and easy to understand guidelines. These guidelines were administered by actual human beings one application at a time.
Most creditors looked at the following criteria:
1. Paying Habits.
This was simply a look at your credit report, your credit history. The length of time you had been “tracked” in the subject credit reporting agency, the age of your “trade” or credit lines (how were you rated by your creditors over at least one year or more) and the presence of any collections, bankruptcies or tax liens. There were also credit exchanges prior to the “Fair Credit Reporting Act” in the early 70’s that tracked locally pertinent credit activity that wouldn’t necessarily show up on your credit report. As examples, this could be Apartment rental agencies, local jewelry stores and “buy here, pay here” auto sales.
2. Ability to Pay.
By checking your tax returns and pay stubs, a potential lender could determine whether or not you had the income (ability) to meet the payment required on the loan you were seeking. Each lender had their own formula for deciding if a potential borrower was “overextended” in their obligations. A factor was used for basic living expenses that took family size into consideration along with the total of all monthly credit obligations including the loan request currently being reviewed. The remaining income had to meet or exceed that lenders formula for “expendable” or “discretionary” income. A common percentage would have been around 40%. This meant forty cents of every dollar of income was available to spend as you see fit.
The length of time you had lived at your current residence address and whether you were buying or renting was considered to be two main measurements of stability. The length of time on your current job was also very important to the stability factor. If you moved constantly or changed jobs frequently, you were thought of as a greater risk. Buying was preferable to renting your residence because ownership was seen as making leaving town less likely than if you were renting.
There was a time when your lender was probably someone you knew from the social events in your area. Maybe you attended the same church or your kids went to school together. The laws of the land also allowed greater intrusion into an applicant’s personal life. Lenders could talk directly to employers, landlords and even neighbors. At any rate the world was smaller and knowing the character of borrowers was easier and often a strong factor in approving or denying a loan request. If your credit report showed a history of small collections, tax liens or repossessions, this would also be thought of as a character issue as well.
In the early 70’s there began to be reports of studies made using multiple thousands of loans that had produced proof that a score system would have had equivalent or better results relative to losses. Credit scoring would also limit human judgment errors in the lending process. By the beginning of the 80’s, credit scoring had been or was being implemented at virtually all the biggest lenders. Determining credit worthiness took a giant step forward when statistical models were built that considered numerous variables and combinations of variables.
Today, with the help of computers, millions of loans can be compared within unlimited categories even though the same 4 elements still apply. This really means you and I will be measured against borrowers with similar situations, incomes and credit histories. Borrowers with limited credit histories will be measured against others of similarly limited borrowing histories and not lumped in with all borrowers. This allows lenders to compare true comparables, ensuring that your credit behavior is judged in a context that is relevant and fair.
As you have probably already realized, the same four factors discussed at the beginning of this writing are still used to build current credit scoring models. The difference now is that they are hidden inside formulas. Score factors are the elements from your personal history that create your credit score. The same factors used for generations are still the driving force behind evaluating credit worthiness.
The scoring method most often quoted is the FICO score. This is a trademark of Fair Isaac Corporation which has been a leader is credit scoring evolution. This chart shows the FICO levels as viewed by lenders.
Score: 760 to 850 (These are the best and highest ratings).
700 to 759 (Almost as strong)
680 to 699 (Average)
640 to 680 (Fair)
620 to 639 (Borderline)
Below 620 is considered high risk.
If you are experiencing credit problems, you have the right to review your own credit report and dispute negative items that you feel are either not legitimate or should be removed due to age or previous payment. Often, old credit blemishes such as unpaid collections can be disputed and because no response will come from the collection agency or lender, the blemish will be removed from your credit report. This should be the beginning of improving your credit score.
In the next segment, discussions will include how new borrowers can start their credit out on solid ground and more on improving marginal credit scores. We will also look further into the FICO scoring criteria