Lesson 4

What is a Credit Score?

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In this video we'll teach you what a credit score is and how lenders use it to determine whether or not to give you a loan

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In the next video we'll look at what affects your credit score
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What is a Credit Score by Credit Virgin

A credit score is a number that tells lenders how risky it is to lend John money. The highest credit score he can have is 850 and the lowest is 300. The higher the better, a high credit score tells lenders that they can trust John to pay back his loan. A low credit score on the other hand well tells lenders they should be cautious about lending John money because he probably won’t pay them back.

So where does this three digit score come from? It all starts with John’s credit history, but only certain things are included on his credit history. These include spending on credit cards, payments on auto loans, home loans, and other types of structured loans. All this activity is combined on a single document to make up his credit history.

There are three main companies that keep up with John’s credit history. Equifax, Experian, and TransUnion. These companies are called consumer reporting agencies or CRA’s and their job is to keep a record of everyone’s credit activity. This is where it gets a little complicated; John’s credit history is not the same as his credit score. His credit score is only based off his credit history.

His credit score actually comes from a company called Fico or the Fair Isaac Corporation. FICO has created a mathematical algorithm that weights the different activities on John’s credit history. First they get his credit history from one of the credit reporting agencies. Next, they send his credit history through their mathematical algorithm. Then it spits out a three digit number also known as his credit score and this tells lenders how risky it is to lend him money. FICO simplifies they loan process for lenders because now instead of having to read everything in his credit history they can just look at a number to decide whether or not to lend John money.

Let’s look at how the process works when someone checks John’s credit score. It’s the same whether someone is checking it for a credit card, a job application, an apartment rental, or even a car loan. For simplicity, we’ll pretend John needs a loan for a new car. John wants to buy at $20,000 car. He plans to pay 10% down, so he’ll need to take out a loan for the remaining $18,000. In order to decide whether or not to give him the loan, the bank will check John’s credit score and credit history.

So here’s how the whole process actually works. John decides he needs a loan for a car. The bank will give him the loan if he has a good credit score and credit history. In order to check these things the bank will request information for one of the three credit reporting agencies. We’ll pretend the car company chooses to work with Equifax. The bank will then pay Equifax for access to his credit history. Before giving his credit history to the car company, Equifax will run his credit history through the fico algorithm. If you remember, this will determine his credit score. Now, the bank will receive both his credit score and a copy of his credit history. They use these two things to determine whether or not to loan John money. Well, it looks like John passed and the car company is willing to lend him money. Hopefully this simple example has helped you understand what a credit score is and how it’s used. In the next video we’ll look at what actually determines your credit score.

About Credit Virgin

Credit Virgin was created for students by students. Our goal is to teach students the importance of building good credit through content that is educational, unconventional, and entertaining

© 2012 Credit Virgin


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