Your credit is your financial reputation. Before you can have access to many financial products and services, your credit will be checked. Your credit is a record of the way you have handled your money obligations in the past. TV service providers, cell phone companies, insurers and even employers are interested in the way you have discharged your financial obligations. Lenders aren’t the only people interested in your credit past anymore.
By looking at your past performance with credit, lenders can get an idea of whether or not you are likely to default, landlords can determine how much trouble they will have getting the rent check each month, and insurers can make judgments about how responsible you are likely to be in general. Decision makers may look at your credit report, your credit score, or both. Understanding the relationship between your credit report and your credit score is important if you want to succeed financially.
Your credit report is a compilation of the credit accounts you have opened in the past. Sometimes it is referred to as your credit history, or your credit file. You actually have more than one credit report, though. Credit reports are compiled by credit reporting agencies. The three main credit reporting agencies are:
When you open a credit account, your creditor reports it, along with the date you opened the account, to at least one of the major credit bureaus. Some employers also report your employment to one (or more) of the credit bureaus. When someone looks at your credit, a record is made, and that is recorded as well.
You should also realize that your payment history is recorded. When you make an on-time payment on your credit card balance, mortgage, or car loan, your credit card issuer reports that to a credit bureau. When you miss a payment, that shows up as well. Non-credit bills are not reported to credit bureaus when you make regular, on-time payments. However, if you miss too many payments, or pay habitually late, a utility company or landlord might decide to report your frequent payment problems to at least one of the credit bureaus. Once that information is included in your credit history, it can affect the way others perceive you going forward.
Other information you will find in your credit report includes your name, aliases, address, previous addresses and Social Security number (you can ask to have only the last four digits displayed). If you wish to make a statement to be included with your credit file, this can be added to your report as well.
With all of your past and present credit accounts listed, it is little surprise that financial services providers want a peek at your credit score. All of the accounts you had, and whether they have been closed are listed, along with payment information going back three to five years. It’s fairly detailed, which makes your credit history an important resource for those trying to make decisions about how much of a financial risk you represent.
Your credit report, with all of its detail, and pages and pages of information, can be somewhat tedious to look through. In order to make it easier for financial services providers to get a quick idea of what kind of financial risk you are likely to be, the information in your credit report is condensed into a single number. This number, known as your credit score, becomes the representation of all the information in your credit report.
There are several different credit scoring models, and they are all based, to some degree, on the information contained in your credit report. The information in your report is assigned a value, which is then plugged into a mathematical formula. The result is your credit score. Different items in your credit report might be weighted differently for the purpose of the score.
FICO Scoring Model: The most widely used credit scoring model is the one developed by the Fair Isaac Company. This credit scoring model provides a scale of 300 to 850. The higher your credit score, the less of a financial risk you are perceived to be. The FICO scoring model relies on five main factors. Although the actual algorithm used in determining your score is a secret, FICO does offer a general overview of what items from your credit report are used:
1. Payment History: This portion includes on-time payments, missed payments and other information. Liens against your assets, as well as bankruptcy and foreclosure, and judgments made against you, are included in this item. How many days delinquent you are, as well as whether or not you are paying on the account as agreed, are part of your payment history. It is the most heavily weighted portion of your credit score, accounting for 35% of your score.
2. Credit Utilization: This is represented by how much of your available credit is being used. If you are close to maxing out most of your credit cards, it is seen as negative. Your credit utilization also includes how much you’ve paid on your installment accounts, and how many of your accounts have balances. Information in a credit report reflecting your credit limit and your available balance is used in this portion of the equation, and accounts for 30% of your credit score.
3. Length of Credit History: Most credit score models, including FICO account for how long you have had your accounts. While the age of your oldest open account is included in the calculations, the “average age” of all of your accounts combined is also part of the equation. This section also includes closed accounts, and who closed them – whether you closed the account or the credit issuer closed the account is part of the calculation. The length of your credit history accounts for 15% of your FICO score.
4. Types of Credit: Values in the algorithm are assigned according to the types of credit you have. Installment loans, like mortgages and auto loans, are considered, as are revolving loans, like credit cards and home equity lines of credit. The FICO scoring model also takes into account “good” debt, like major credit cards, and “poor” debt, like payday loans. 10% of your credit score comes from this factor.
5. New Credit: When you open a new credit account, that is factored into the FICO score. A new credit application (even if it is rejected) or a new account can lower your credit score. Additionally, the time between credit inquiries is included, as is the re-establishment of positive credit items after a poor past. This factor makes up 10% of your FICO score.
You should understand that FICO markets its credit score model to financial services providers. FICO tweaks its scoring model to reflect different behaviors. For instance, the FICO Mortgage Score has a tweak in the formula to emphasize mortgage payments over other types of payments. The Expansion Score is actually tweaked to included items like on-time rent payment, even though it usually isn’t a factor in the “regular” FICO score.
Other Credit Scoring Models: On top of FICO’s tweaks, some lenders and credit bureaus introduce their own variations. An auto lender might tweak the scoring model to focus on past car payments. Many banks create their own credit scoring models to reflect their preferences for risk. Experian has its own scoring model, the PLUS score, and the three credit bureaus have created the VantageScore to compete with FICO.
However, FICO, and versions of FICO, remain the most prominent scoring models. The differences in scoring models, as well as which credit bureau’s report is used as a basis for the credit score, means that you actually have several different scores. You can ask the lender or insurer which score is used so that you can get a better idea of how you are being evaluated.
Before you apply for a major loan – especially a home loan or a car loan – it is a good idea to check your credit. When you check your own credit, it won’t be included as a “hard” inquiry in your credit report, and it won’t be factored into your credit score. Having an idea of what’s in your credit report, and knowing your credit score, will prepare you. If you have a low score, you will have to pay a higher interest rate, or you may be denied altogether. When you have a score that is lower than you anticipated, it is a good idea to hold off on your application and make an effort to improve your credit score.
Looking at your credit report can give you an idea of where you need to make improvements. Additionally, you might find inaccuracies in your credit report that are contributing to a lower score than you should have. Fixing mistakes on your credit report before you apply for a loan can save you hundreds (or even thousands) of dollars in interest.
You are entitled to a free copy of your credit report, one from each of the three major bureaus, every 12 months. You can access your free reports by visiting www.annualcreditreport.com. You can also see a free copy of a credit report if it is used to deny you a loan, a better insurance premium, a service (TV or cell phone), or a job. You can get access to your credit report at each of the three credit bureaus, as well as by visiting www.myFICO.com (where you can also see a copy of your FICO score).
Starting July 21, 2011, you will be entitled to see a free credit score if the model is used to deny you credit, or is used to justify charging you a higher interest rate. Right now, there is no provision in the law for you to see a free copy of your credit score every 12 months like there is for seeing your credit report, although you can see versions of your score for free at www.CreditKarma.com and www.Quizzle.com. Each of the three major credit bureaus will sell you a copy of your credit score as well.
Even though you can’t see your “official” credit score for free, you can get a general idea of whether it is good or bad with the help of your credit report. Since the information in your credit report is used to determine your credit score, making sure that your credit report is accurate can be helpful. You can also develop good money habits by:
1. Making all of your payments on time, and in the expected amount.
2. Paying more than the minimum on your revolving lines of credit.
3. Paying down your debt as fast as you can – especially paying down your credit cards. This includes paying off your credit card balance each month.
4. Avoiding debt you don’t need. Live within your means, and try to borrow only when you need to, such as for large purchases like homes, cars and education. Even when you receive loans for such items, make sure to borrow as little as possible.
It can take some time to fix bad credit, though. Be patient as you work toward improving your credit history. Some items, like bankruptcy, can remain on your credit report for years. However, if you can show that you are making solid improvements, you will gradually be allowed to borrow again – and at better rates.
Of course, the best course is to start out with good credit. You can build good credit by carefully considering how much you borrow, paying bills on time, and paying off your loans as quickly as possible. You do need to use credit if you want to build a credit history. No credit history can be just as bad as a poor credit history, especially if you want to buy a home. With careful and considered use of credit, you can avoid being overwhelmed by debt while bu