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Bundling: Is your company prepared?

National Mortgage Professional
Jun 05, 2005

The world of credit: Creation of a credit scoreJohn J. Hudockcredit ratings, credit management, deductions, scoring process The purpose of your credit score is to give a lender an indication of your credit worthiness. Credit worthiness is defined by the Fair Credit Reporting Act §603 Definitions; rules of construction [15 U.S.C. §1681a] (d) Consumer report. (1) In general. The term "consumer report" means any written, oral or other communication of any information by a consumer reporting agency bearing on a consumer's credit worthiness, credit standing, credit capacity, character, general reputation, personal characteristics or mode of living, which is used or expected to be used or collected in whole or in part for the purpose of serving as a factor in establishing the consumer's eligibility. This number developed by Fair Isaac Company (FICO) is a simplified comparison designed to be a reflection of your past credit habits. It is a three digit numerical system, with the range of 350 as the lowest indicator to 850 as the highest. I have indicated the average score to be about at 640. FICO lists the average as 723. The score of 640 is called a conforming score that will allow you to get average or prime financing. A score of 720 and above is considered a preferred score and will get you the lowest interest rate the lender has available. A score below 500 is considered minimal or no credit. This is generally cause by a lack of open active tradelines. These are tradelines that have no derogatories (payments 30 days late or more). Once a derogatory is placed on any tradeline, it will remain there up to seven years unless removed by the creditor. Any comments or information placed on a credit report is at the discretion of the creditor. Whether this information is correct or not, it can only be removed by the creditor unless it reaches the time limitations set by law. The time limitation for credit derogatories is seven years; for bankruptcies, it is 10 years; and for public records, it is 10 years. FICO developed the risk scoring models for all national repositories in 1991. FICO uses a segmented scoring system, a closely guarded proprietary factoring method for scoring credit reports. Very few individuals--even key employees at FICO--understand the exact method for deductions. FICO claims to use segmented tree algorithms in their probability determinations. Tree search algorithms are specialized versions of graph search algorithms, which take the properties of trees into account (a tree is a hierarchical structure like an organization chart). Tree search algorithms are the inert heart of searching techniques. These search nodes of trees, whether that tree is explicit or implicit (generated on the go), are collected. A node is a basic unit used to build data structures, such as linked lists and tree data structures. Nodes contain data and/or links to other nodes. Links between nodes are often implemented by pointers or references. A basic principle is that a node is taken from a data structure, its successors examined and added back to the data structure. By manipulating the data structure, the tree is explored in different ordersfor instance, level by level and backtracking. FICO is statistically predicting the likelihood that a given event will occur. The results are expressed as the ratio of the number of actual occurrences to the number of possible occurrences. Regrettably, this data could be five or more years old and not a true reflection of current financial status. This is a major area of concern because if the data that FICO is using is accurate, then the formulas will arrive at the correct assumptions. Unfortunately, a recent independent study of more than 500,000 consumers conducted by the National Credit Reporting Association and the Consumer Federation of America determined that there are scoring variations and errors in 78 percent of all consumer files. Historically, when these areas are injected into the FICO formula, scores are lowered. The credit scoring process is actually much more complex than what I have been presentingit is a very sophisticated portrayal of segmented scoringthat is, there is no absolute fixed deduction for any considered action; the deduction is relative to the entire credit report. Therefore, a single 30-day late is not a 20-30 point deduction or a five-10 point deduction from the score, rather all factors on the specific report are considered in the total score reduction. The deduction for a credit report with 10 tradelines will not be the same as a credit report with 30 or 40 tradelines. To determine the general make up of the specific tradeline we must separate the lines into four categories: open, closed, derogitories and public record. Each category has distinct areas of deductions. We determine the approximate deductions for each tradeline, compile the amounts of these deductions and reverse calculate to equal the total deduction from each repository. Areas considered for deductions Open accounts 1. Number of Accounts (a minimum of three to four required) 2. Months/reviewed (based on 24 months) 3. Amount of balance to high limit 4. Type of account (revolving and credit cards) Closed accounts 1. Number (best kept under 16) Derogitories 1. Months/reviewed (based on 24 months) 2. Number of 30 days late 3. Number of 60 days late 4. Number of 90-plus days late Public record 1. Active one to 12 months with balance 2. Active 13-24 months with balance 3. Active 25-36 months with balance 4. Active more than 36 months with balance 5. SatisfiedLess than 12 months 6. SatisfiedMore than 12 months The areas considered for deductions are illustrating gradations in the level of risks, and the following tables will show that the impact varies with time and the seriousness of the derogatory entry for each of the categories. The first is late payments--next to having no credit, one of the larger deductions is for the late histories. A creditor determines your creditworthiness by your past payment patterns. They rely on your past history to predict your future probability of repayments. Late payments can be divided into four major categories: •30 days late •60 days late •90 days late •120-plus days late Factor deductions for each tradeline are also relative to the months the account has been reported to each of the three repositories. First 12 months •30 days late--18 •60 days late--22 •90 days late--28 •120-plus days late--32 Second 12 months •30 days late--15 •60 days late--20 •90 days late--25 •120-plus days late--29 Third 12 months •30 days late--12 •60 days late--10 •90 days late--15 •120-plus days late--19 Factor deductions for the variables in public records Date active (with balance) •First 12 months--32 •Second 12 months--28 •Third 12 months--20 •More than 36 months--1 and 8 Date active (satisfied) •First 12 months--15 •Second 12 months--10 •Third 12 months--5 •More than 36 months--3 As you can see, there is a relationship in time for tradelines with balances and the ones that are satisfied. The deductions that I am highlighting are for a specific total credit report and vary with the number of tradelines in each of the specific categories. It also appears that in many situations, the repositories are showing judgments and liens as open although they have been satisfied. We provide documentation of satisfaction from the courthouse to the repositories and the judgment or lien is removed. In subsequent reporting periods, the judgment or lien is placed back on the credit report. If the repository was required to inform you when any derogatory was placed on your credit report, you would recognize the error before it causes you additional problems. Two other areas considered for deductions are the date of last activity and the ratio to high limit. 1. Select all open revolving accounts with any balances. 2. Use table to determine point deduction for each tradeline. Balance Deduction •No balance--No deduction •1-15 percent--5 points •16-25 percent--10 points •26-50 percent--20 points •51-70 percent--25 points •71-75 percent--30 points •76-90 percent--35 points •91-100 percent--50 points •101 percent-plus--60 points The points illustrated as deductions cannot be applied to any tradeline. The numbers shown are to a specific credit report. I wanted to show you the gradation in deductions. The actual deduction is in a curve, not a table, and I have selected periods in the curve to develop a table. The specific deduction is related to the number of trade lines. In reality, the more tradelines you have with higher balances, the less deductions for each of the tradelines. When this occurs, the total deductions for all of the tradelines will be higher. Additional considerations Date of last activity (DLA), number, types and dates of inquiries and credit mixed (the type of each trade line), revolving accounts, installment accounts, mortgage, auto or education, are also considerations. It is very difficult to analyze or assess a credit score manually; there are just too many variations. The International Credit Club and The World of Credit have developed a software method that considers all of these aspects. If you wish any further information, please contact me. John Hudock is president of The International Credit Club and The World of Credit, two companies specializing in credit report problems and scores. He can be reached at (570) 829-5696 or e-mail [email protected] John invites e-mails on any credit topic. He will answer each one and publish any that will benefit his readers. Please feel free to be specific with your questions.
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