Many have asked the big question, just to never receive an answer. Even if you call the credit reporting agencies you will still not receive and answer. The answer lies in the credit reporting agencies’ credit scoring algorithm. *The answer will be listed after a few basics are defined.*
Definition of Algorithm
: a procedure for solving a mathematical problem (as of finding the greatest common divisor) in a finite number of steps that frequently involves repetition of an operation;
Broadly : a step-by-step procedure for solving a problem or accomplishing some end especially by a computer
Basic Credit Scoring
Common knowledge has been that the credit scoring algorithm calculates credit scores based on consumer information. That information including job time, residence time, number of credit inquiries, negative public records (judgments, liens, bankruptcy), (home) phone number, positive and negative credit accounts, and length of credit history.
Certain types of accounts also help to determine the consumer’s credit score. For instance high risk lenders generally carry the word “financial” in their titles and that scores lower in the algorithm. If you look closely at your revolving and installment accounts on your credit report/s you will notice the terms (length the account will be or has been paid, the credit limit or original amount, and the payment) are listed. This definitely plays a role in the scoring because it determines the history of the account.
Loans and Payments
To determine what the payment will be on a revolving or installment account the financial institution will use a loan amortizer. The amortizer takes the loan amount, the interest rate and the months of the contract to calculate the monthly payment. That is a simple description that applies to installment accounts (home loans, auto loans, signature loans, ect…). Revolving accounts have a few more factors involved.
*Note: For years, consumers that had credit cards that did not reflect a “high credit” amount used to have lower credit scores because the account scored as being “maxed out”. This used to happen with American Express and many department store cards that were backed by American Express.*
Time for the answer
With an algorithm that is so complex it is very easy to not only amortize an account but to reverse amortize an account. In other words there is enough information given to the credit reporting agencies that it can calculate the amount of interest a consumer is paying on each revolving and installment account. The information (interest rates) is not listed because it would be a conflict of interest for the credit bureau subscribers. Meaning, if consumer “A” has an interest rate of 12% on a credit card and it is listed on their report, it is more a reminder to find a better interest card when the opportunity presents itself. Out of sight is out of mind. Back to the answer… As interest rates change (going up or down), credit scores are affected as well. If the prime rate goes down and the rates of your accounts are ‘higher’, your scores will most likely go down.
*Note: Another example of this would be in the automobile industry. If the manufacturer of a specific make and model of a vehicle lowers the cost of that model (new) to the dealerships, it will affect the value of the model for previous years.*
Now that you know this, the next question might be, “Why don’t my scores go up when the prime rate goes upward?” The short answer is because consumers are in third place when it comes to interest rates. The Federal Reserve is in first position, the banks are in second and the consumer is third. Third place gets the last “set” interest rate. Meaning, when a lending institution issues credit, the consumer will never have a better rate than the lending institution. More will be written about that at another time.