Credit score is more crystal ball than report card

This post originally appeared December 15, 2016 on CreditCards.com as “How credit scores attempt to predict the future

By Barry Paperno

Dear Speaking of Credit,
Barry, not a question. A comment. I read your explanation as to why “hard pulls” lower your credit score. What I think I boiled it down to is this: it is based on statistical trending, not on me. Now, my score is 825, so I am not particularly worried, except that I do NOT dip in my likelihood of paying on time because of, say, a new loan for a (used) car. So I take exception to the assumption that I will perform like the statistical masses and start paying with lower consistency.

This feeling is further exacerbated because they know enough intimate detail about my history to be 99.9 percent certain that there will be no fluctuation, since there never is. So, in the end I take exception to the practice as unnecessary on such a broad scale and with so much INDIVIDUAL historical information available. – Christopher

Dear Christopher,
Considering the abundance of historical credit information on file at the credit bureaus, I agree that your 825 credit score – out of a maximum of 850 – should leave no doubt that over the years you have managed your credit exceptionally.

However, purely historical data like this doesn’t tell us everything about your creditworthiness. What your credit report alone fails to provide are the odds that, despite your stellar past, you will continue to manage your credit as responsibly going forward. Yet this is exactly what every lender really wants to know before granting credit. That is, which consumers with bad credit histories will be future good payers and who among those with good credit will go bad.

Do consumers with stellar histories like yours ever run into financial problems? Of course they do. Job loss and serious illness are just two examples of unexpected consequences that can affect a financially responsible consumer’s ability to continue paying on time. Conversely, a consumer who has experienced setbacks in the past and has some poor-looking credit reports to show for it, may have turned things around and is now back on the good foot.

In other words, what lenders really want to be able to do is identify the diamonds in the rough as well as the accidents waiting to happen. Knowing this enables them to take steps that can increase profits and minimize future losses from existing and new borrowers by establishing appropriate credit lines and approving consumers presenting the lowest future risk of nonpayment.

This is where credit scores come in. If a credit report paints a picture purely of the past, the picture a credit score paints is not only of the past, but more importantly, the future.

Credit score developers, such as FICO and VantageScore, accomplish this future-predicting feat by identifying which credit bureau information tends to most effectively predict future creditworthiness.

Examples include:

From this information, a credit scoring formula is created that rank-orders risk by assigning points to each scoring factor according to its ability foresee what lies ahead. Factors indicating low risk – on-time payments, low card debt and long credit history – reward the consumer with more points. By the same token, higher risk indicators, such as late payments, high balances and a short credit history, provide fewer points and a lower score.

The information used to create these scores is gathered from the real credit history experiences of millions of consumers via their credit reports. These credit reports tell the stories of how consumers have managed their credit over a (typically) two-year time span.

From this data, a set of consumer profiles made up of the most common factors leading to the various outcomes are established. They cover a range that extends from consumers who pay all accounts as agreed, on one extreme, to those who file for bankruptcy on the other – with various stages of credit performance in between. Your score is then determined by how closely your credit report compares to the profile that most closely matches your experience.

So, despite you not seeing yourself as one of the “statistical masses,” by applying statistical methods to this data representing the experiences of millions of consumers, the score essentially sets the odds of your future payments being on-time or late. While never 100 percent accurate – good scorers can go bad and bad scorers good – validations by lenders over the years have shown credit scores to be surprisingly effective in their predictions.

Relating all of this to your situation, research into the relationship between new account openings and future credit problems has found that, when all other factors remain equal, a slightly higher likelihood of future credit difficulties tend to occur when a consumer takes on a new credit obligation. An inquiry’s value is that it can be the earliest indicator of a new account opening on the horizon.

We don’t know how many points were lost due to your inquiry, nor do we know exactly what the appearance of that new loan on your credit report has done or will do to your score. What we do know is that an inquiry, while being an early “red flag,” is also one of the least predictive score factors in the formula with very few points at stake – about five points on average.

Again, it’s understandable why you might object to seeing your super-high score impacted by a rather meaningless inquiry using statistics that may not apply to you. If it will help, perhaps just think of your score as a reliable-but-imperfect crystal ball that provides one of the best looks into the future a lender can depend on.

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