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Financial health: Clearing credit score confusion

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Sunday, November 20, 2011

Most people are aware that their credit reports and credit scores are two vital pieces of information when it comes to having a consumer loan approved. We generally refer to our “credit score” without having any knowledge of the company that created it.

Until recently credit scores were the product of a mathematical formula developed by the Fair Isaac Corporation, a California-based company that developed the first credit scoring system. The FICO score, as it is known, uses a scale that runs from 300 to 850 with the significant majority of consumers falling between 600 to 799. Should you be so fortunate as to have a score of 800 or higher, you share that distinction with only 13 percent of all consumers.

Understandably, companies looking to sell their products or property actively seek those individuals with credit scores in the 800-plus range since they represent a modest financial risk. These consumers can get credit approved for a purchase in minutes or qualify for a loan without a series of questions about annual salary and personal liabilities. This is especially true when the vendor knows the consumer from previous transactions.

The FICO credit score is derived from a mathematical formula that uses information taken from your credit report, such as the number of cards you have, the balance owed on each card, late payments for any loan, and the total number of consumer loans as a percentage of gross annual income. For years the FICO scoring system went unchallenged, but that changed a few years ago when three major credit bureaus — Equifax, Experian, and TransUnion — began developing their own algorithms.

The reason these firms decided to include the creation of credit scores with their already lucrative business of credit reporting is that when they market their own credit scores no royalty is owed to the Fair Isaac Corporation.

Equifax produces its BEACON credit score, while Experian has a score it refers to as Experian/Fair Isaac Risk Model. TransUnion has developed the EMPIRICA credit score. Now there are four competing companies that develop and sale credit scores to both consumers and vendors, such as car dealerships, seeking to finalize a purchase transaction with a customer.

The mere availability of these varying credit scores significantly is affecting consumers in the marketplace because the number scales used for each one is different. With consumers so accustomed to FICO’s 300 to 850 numerical scale, and with so little awareness of the other three credit scoring systems, the mention of a “credit score” during a purchase transaction immediately infers a FICO score.

With so much potential confusion, Congress passed legislation in July 2010 that applies to situations where a consumer does not receive the best terms on a loan, an insurance policy application, a credit card or a utility. In these cases the consumer must be shown the credit score and company that were used, and this must be done at no cost to the consumer.

The next development in the credit scoring competition involves all three credit reporting bureaus. They have joined forces and developed a new credit score called VantageScore that is available to vendors and consumers. VantageScore uses a credit scoring range that runs from 501 through 990 and was developed because of the differences between the three scores offered by each of the companies. By merging, they hope to dominate the credit score market, thereby striking what could be a fatal blow to the Fair Isaac Corporation.

What matters most to consumers in all of this credit score turmoil is to be sure you know which company’s score was used to determine your credit eligibility and to have basic familiarity as to the various scoring ranges. The reason is that a credit score difference of just 100 points could cost you thousands of dollars even if you are approved for the loan.

Jack E. Karns is a professor of business law in the College of Business at East Carolina University.

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