Purpose and Management
of your Credit Score

Credit scores are so ingrained in our society it almost seems like they have always been there. Most people realize that your ability to buy a home, get a car loan, rent an apartment, or even get a job can depend on one simple number, your credit score. What many people don't know, however, is the reasoning behind having a single credit score, how the modern practice of assessing a credit score came into being, and how your credit score is used to determine credit risk.

The Creation of the FICO Score

Prior to the 1950s, when a person would apply for a line of credit the creditor would reference their credit reports to determine the credit risk. They would scour the reports line by line looking for delinquent account, payment history, open lines of credit, and other indicators that helped them assess risk. They would then make the decision of whether or not to extend credit and how much interest to charge.

In hindsight, it is easy to see the opportunity for error and discrimination. Determining whether or not a person would default on their loan was an inexact science and many people were denied credit on the basis of their race, gender, occupation and various personal traits. It is also easy to see the difficulty of scaling such a system. In today's society, it is simply not practical for a lender to manually asses a person's credit risk by looking through their credit reports.

To overcome this obstacle, a group of statisticians at Fair Isaac Corporation (FICO) devised a mathematical algorithm that calculated a persons credit risk based on the items in their credit reports. What resulted was a credit score where the higher the number, the lower the credit risk. Now lenders could quickly assess a potential borrower's credit risk. Instead of looking through the individual items in the credit report, all they had to do was trust the FICO model and the credit score it produced.

The Problems with Credit Scoring

Even though the credit scoring process reduced many of the problems symptomatic of the old system and has proven to be very scalable, it introduced a new set of problems that we are struggling to deal with today. The problems stem from the fact that unlike the previous method of looking at credit reports on an individual level, credit scoring is a macro process. People are classified into groups according to the overall credit risk of that group.

From the lenders point of view, the grouping system works well. They can look at a credit score and reasonably assume that a set percentage of people with that credit score will be delinquent with their payments or default on the loan. They can then use the percentage in their calculations and determine if they are willing to lend to that group of people and how high of an interest rate is necessary to offset the risk.

From the consumer perspective, however, the majority of people end up suffering unfairly. For example, suppose that consumers with a particular credit score are projected to default on their loan 5% of the time. When lenders extend credit to this group, they will do so at an interest rate that accounts for the 5% default rate. They will make sure the remaining 95% of the people pay enough in interest payments to negate the losses they incur from the 5%. For lenders this is great. For the 95% of consumers, it means they are paying higher rates to account for the fact that others will default.

The Importance of Having Accurate Credit Reports

Since credit scores are based on the items in your credit report, it is imperative that your credit reports are an accurate representation of your credit risk. Unfortunately, the credit bureaus cannot be counted on to ensure this is the case. Studies show that up to 80% of all credit reports contain errors that may negatively affect credit scores.

As a consumer, this means your credit score is lower than it should be and lenders are grouping you with other consumers who are a higher credit risk than you are. Not only are you going to have to pay extra interest to account for the people in your group who will default on their loan, but you are also paying an even higher rate than usual because you are being grouped incorrectly.

Make Your Credit Score an Accurate Representation

By ensuring the information included in your credit reports results in a credit score that accurately portrays your credit risk, you can avoid having to pay interest rates in excess of what is fair. Doing so can save you hundreds of dollars off credit card bills or hundreds of thousands of dollars over the life of a mortgage.

Fixing the errors in your credit report is known as credit repair. Credit report repair is a process that is regulated by the federal government and allows you to dispute negative items in your credit reports. Legislation allows you to dispute any negative items you feel are "inaccurate, unverifiable, or misleading."� This gives you considerable leeway in disputing items you feel are unfairly included in your credit report and unfairly lowering your credit score.

Credit repair gives you the opportunity to have a say in your credit reports and to indirectly improve your credit score. Since credit scores have become such an integral part of modern society, making sure your credit score is a good as it can be is one of the most important things you can do for yourself.