Income is Not a factor in Credit Scoring Models
I’ve frequently heard from participants in my “Credit and the Interest Insomniac” workshops, as we discuss credit reports and scores and how they have a real dollar-value impact on household finances, that it is not fair that individuals with less income have to pay higher interest rates. This is especially true when I show how an individual with poor credit would pay $2,000 to $4,000 more annually for the same house as an individual with excellent credit. Participants assume that the person with poor credit is a low-income individual and the one with excellent credit is a high-income individual.
My response to this is direct and simple: income is not a factor in the credit scoring models used by most lenders. In fact, income is not found anywhere on an individual’s credit report (also known as a credit file, a credit record, or as their credit history). In simplistic terms, the five factors of a credit score are 1) whether or not you at least make your minimum payment on time each month, 2) whether or not you’ve maxed out your credit accounts, 3) how old your credit accounts are, 4) whether or not you’re applying for a lot of new credit accounts, and 5) the variety of credit accounts you have, such as credit cards, mortgage, auto loan, store card, etc.
Nowhere in these factors will you find income. Individuals with low-income, who properly use and repay the limited credit accounts they may qualify for, can build very decent credit. Conversely, high-income individuals who overspend and then abuse their credit cards can end up with a terrible credit score. On an individual basis, income has no direct or indirect impact on credit scores.
That said, we do have to acknowledge the reality side of this topic: credit bureaus and, consequently, creditors are able to generalize an income range for individuals of a given credit report profile. Essentially, they can determine the likelihood that a group of individuals who meet certain credit report criteria has a certain annual household income. The key words here are “likelihood” and “group.” It’s not a perfect formula, and certain data on a credit report indicate a corresponding income level for the group as a whole, not individually. However, there will certainly be individual variances.
So what can we take from this? Well, we in the Financial Education department at Debt Reduction Services Inc continually preach personal responsibility when it comes to personal finances. This is the case again here. In short: responsibly use whatever credit you have, whether it’s a small amount limited by low-income levels or whether it’s nearly unlimited because of being from a high-income household. Credit scores depend much more on what you DO with the credit you have than with HOW MUCH credit you have.
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