Understanding Credit
Why is it important to know your credit score and how credit works?
It’s hard if not impossible to go through life without needing credit. Whether you are buying a home or renting a car, access to credit has become increasingly important. Knowing what your credit report contains, and knowing your current credit score is information you need when trying to secure a favorable rate for a mortgage, credit card or any other type of loan.
Lenders will look at your credit history and credit score to determine whether they’ll give you a loan and to determine the interest rate they’ll charge. The better your credit score, the better your chances are of obtaining a loan with a lower interest rate. And a lower interest rate can end up saving you thousands of dollars! Always make sure you check your credit report before applying for credit so you can correct any inaccurate data that may hurt your score.
It’s important to have an understanding of how credit scores are calculated. Knowing how data is collected and how it contributes to your score will help you improve it.
Credit Bureaus
Who are the Credit Bureaus?
A Credit Bureau is a company that collects information about consumers’ credit. When you apply for credit they provide information to the creditor. There are three main credit bureaus; Experian, Equifax, and TransUnion.
How do they get their data?
Creditors (including any financial institutions, stores, loan offices, collection agencies etc.) send information to the bureaus. However a creditor may not send information to all three bureaus. The bureaus do not share information among themselves. So the information contained in the credit report of each bureau will be different. For this reason, it is important to know what all three bureaus are reporting about you.
Credit Data
Who can access this data?
The Fair Credit Reporting Act (FCRA) states who can access your credit report and under what circumstances. Creditors, insurers, employers, and other businesses that use information in your credit report to evaluate your applications for credit, insurance, employment or renting a home have a legal right to access your credit report.
Here are some examples of these companies:
- Insurance companies
- Landlords
- Credit Card Companies
- Potential Employers (with your written permission)
- State and Local Child Support Enforcement Agencies
- Lenders
- Banks
If an organization accesses your credit report outside of the FCRA guidelines they can be fined and jailed for up to a year.
When one of these organizations requests and accesses your report it is considered a “hard inquiry”. Too many hard inquiries on your report can hurt your credit score. Remember that ordering your own credit report is considered a “soft inquiry” and does not affect your credit score. Soft inquiries are not visible to creditors who view your credit report, but will show on a credit report you request.
For more information on the Fair Credit Reporting Act visit: www.ftc.gov/enforcement/rules/rulemaking-regulatory-reform-proceedings/fair-credit-reporting-act
Credit Score
How are credit scores determined?
A credit score can range from 300 – 850. Credit scores vary depending on the bureau (Experian, TransUnion, and Equifax), type of score (FICO, Vantage, etc.) and type of lender (mortgage, credit card, etc.). You probably have hundreds of different credit scores but the one you receive will depend on who you ask.
Your Experian score and may be different from your TransUnion score due to differences in the credit report data reported to each bureau. Since the bureaus do not share data and not all creditors report to all three bureaus you will see slight differences in your score.
Also scores can vary depending on the scoring model used. Two of the biggest scoring models are the Fair Isaac and Company (FICO) and Vantage. They consider all three of the main credit bureaus data to determine one overall credit score. However they use different scoring models that weight specific information differently.
Some lenders use custom scoring models. For example when you apply for a credit card, the lender may request a bank card industry option score which takes the basic formula and adjusts certain information that may do a better job of predicting if a consumer will pay back that specific type of debt.
Although your score may differ depending on the bureau, type of score, or industry these scores tend to be similar just with slight differences depending on the data and scoring formula used.
Let’s take a look at how one score is determined. This is how the Fair Isaac Corporation (FICO) determines a credit score:
35% of your score is determined by your payment history. Do you pay your bills on time?
30% of your score is determined by the ratio of available credit and amount owed. So if you have $10,000 in available credit with $1000 owed your ratio is 10:1; that is good. If you have $10000 available credit and owe 9,000, the ratio is 10:9 which means you are over extended.
15% of your score is determined by the length of your credit history. How long have your accounts been open and active?
10% is the variety of types of credit. For example credit cards, installment loans and mortgage loans are all different types of credit.
10% is new credit. If you have opened a bunch of new credit lines your score may drop. Lenders worry that you may be overextending yourself.
For more information on how a FICO score is determined visit: www.myfico.com/crediteducation/whatsinyourscore.aspx
