Credit plays a critical part in nearly everyone's life, but understanding
what credit is and how it works can be a challenge. A great way to understand
the role credit plays in your life – and to empower yourself as a
consumer – is with a basic knowledge of two credit fundamentals: Credit
Scores and Credit
Reports.
Your credit score is a number based on the information in your credit file
that shows how likely you are to pay a loan back on time – the higher your
score, the less risk you represent. The credit score that lenders use is called
a FICO® score. Your FICO score helps a lender determine whether you qualify for
a loan and what interest rate you'll pay.
- What's in Your Score
- Knowing what information a FICO score considers is the first step in
understanding how to improve your credit health and build a better score.
Although each credit reporting agency formats and reports this information
differently, all credit reports contain basically the same categories of
information. Your social security number, date of birth and employment
information are used to identify you. These factors are not used in scoring.
Updates to this information come from information you supply to lenders.
- Identifying Information.
Your name, address, Social Security number, date of birth and employment
information are used to identify you. These factors are not used in
scoring. Updates to this information come from information you supply to
lenders.
- Trade Lines.
These are your credit accounts. Lenders report on each account you have
established with them. They report the type of account (bankcard, auto
loan, mortgage, etc), the date you opened the account, your credit limit
or loan amount, the account balance and your payment history.
- Inquiries.
When you apply for a loan, you authorize your lender to ask for a copy of
your credit report. This is how inquiries appear on your credit report.
The inquiries section contains a list of everyone who accessed your credit
report within the last two years. The report you see lists both
"voluntary" inquiries, spurred by your own requests for credit,
and "involuntary" inquires, such as when lenders order your
report so as to make you a pre-approved credit offer in the mail.
- Public Record and Collection Items.
Credit reporting agencies also collect public record information from
state and county courts, and information on overdue debt from collection
agencies. Public record information includes bankruptcies, foreclosures,
suits, wage attachments, liens and judgments.
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- What's Not in Your Score
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- Your credit file contains information that does not reflect on your
creditworthiness - such as race or income - which is ignored by the FICO
score.
- Your race, color, religion, national origin, sex and marital
status.
US law prohibits credit scoring from considering these facts, as well as
any receipt of public assistance, or the exercise of any consumer right
under the Consumer Credit Protection Act.
- Your age.
Other types of scores may consider your age, but FICO scores don't.
- Your salary, occupation, title, employer, date employed or
employment history.
Lenders may consider this information, however, as may other types of
scores.
- Where you live.
- Any interest rate being charged on a particular credit card or
other account.
- Any items reported as child/family support obligations or rental
agreements.
- Certain types of inquiries (requests for your credit report).
The score does not count “consumer-initiated” inquiries – requests
you have made for your credit report, in order to check it. It also does
not count “promotional inquiries” – requests made by lenders in
order to make you a “pre-approved” credit offer – or
“administrative inquiries” – requests made by lenders to review your
account with them. Requests that are marked as coming from employers are
not counted either.
- Any information not found in your credit report.
- Any information that is not proven to be predictive of future
credit performance.
- Whether or not you are participating in a credit counseling of
any kind.
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- How Scoring Helps You
- FICO scores provide a fast, objective measurement of your credit risk,
which has a number of benefits for you.
Credit scores give lenders a fast, objective measurement of your credit
risk. Before the use of scoring, the credit granting process could be slow,
inconsistent and unfairly biased.
Credit scores – especially FICO® scores, the most widely used credit
bureau scores – have made big improvements in the credit process. Because of
credit scores:
- People can get loans faster.
Scores can be delivered almost instantaneously, helping lenders speed up
loan approvals. Today many credit decisions can be made within minutes.
Even a mortgage application can be approved in hours instead of weeks for
borrowers who score above a lender's “score cutoff”. Scoring also
allows retail stores, Internet sites and other lenders to make “instant
credit” decisions.
- Credit decisions are fairer.
Using credit scoring, lenders can focus only on the facts related to
credit risk, rather than their personal feelings. Factors like your
gender, race, religion, nationality and marital status are not considered
by credit scoring.
- Credit “mistakes” count for less.
If you have had poor credit performance in the past, credit scoring
doesn't let that haunt you forever. Past credit problems fade as time
passes and as recent good payment patterns show up on your credit report.
Unlike so-called “knock out rules” that turn down borrowers based
solely on a past problem in their file, credit scoring weighs all of the
credit-related information, both good and bad, in your credit report.
- More credit is available.
Lenders who use credit scoring can approve more loans, because credit
scoring gives them more precise information on which to base credit
decisions. It allows lenders to identify individuals who are likely to
perform well in the future, even though their credit report shows past
problems. Even people whose scores are lower than a lender's cutoff for
“automatic approval” benefit from scoring. Many lenders offer a choice
of credit products geared to different risk levels. Most have their own
separate guidelines, so if you are turned down by one lender, another may
approve your loan. The use of credit scores gives lenders the confidence
to offer credit to more people, since they have a better understanding of
the risk they are taking on.
- Credit rates are lower overall.
With more credit available, the cost of credit for borrowers decreases.
Automated credit processes, including credit scoring, make the credit
granting process more efficient and less costly for lenders, who in turn
have passed savings on to their customers. And by controlling credit
losses using scoring, lenders can make rates lower overall. Mortgage rates
are lower in the United States than in Europe, for example, in part
because of the information - including credit scores - available to
lenders here. Knowing and improving your score can also lead to more
favorable interest rates. Check
out an example of the national averages of interest rates and see exactly
how much money you might be able to save.
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- Improving Your Score
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- By understanding what lenders view as good credit management, you can
build a strong credit history, improve your score and qualify for better
loan terms.
It’s important to note that raising your score is a bit like losing
weight: It takes time and there is no quick fix. In fact, quick-fix efforts
can backfire. The best advice is to manage credit responsibly over time. See
how much money you can save by just following these tips and raising your
score.
Payment History Tips
- Pay your bills on time.
Delinquent payments and collections can have a major negative impact on
your score.
- If you have missed payments, get current and stay current.
The longer you pay your bills on time, the better your score.
- Be aware that paying off a collection account will not remove it
from your credit report.
It will stay on your report for seven years.
- If you are having trouble making ends meet, contact your
creditors or see a legitimate credit counselor.
This won't improve your score immediately, but if you can begin to manage
your credit and pay on time, your score will get better over time.
Amounts Owed Tips
- Keep balances low on credit cards and other “revolving
credit”.
High outstanding debt can affect a score.
- Pay off debt rather than moving it around.
The most effective way to improve your score in this area is by paying
down your revolving credit. In fact, owing the same amount but having
fewer open accounts may lower your score.
- Don't close unused credit cards as a short-term strategy to
raise your score.
- Don't open a number of new credit cards that you don't need,
just to increase your available credit.
This approach could backfire and actually lower score.
Length of Credit History Tips
- If you have been managing credit for a short time, don't open a
lot of new accounts too rapidly.
New accounts will lower your average account age, which will have a larger
effect on your score if you don't have a lot of other credit information.
Also, rapid account buildup can look risky if you are a new credit user.
New Credit Tips
- Do your rate shopping for a given loan within a focused period
of time.
FICO® scores distinguish between a search for a single loan and a search
for many new credit lines, in part by the length of time over which
inquiries occur.
- Re-establish your credit history if you have had problems.
Opening new accounts responsibly and paying them off on time will raise
your score in the long term.
- Note that it's OK to request and check your own credit report.
This won't affect your score, as long as you order your credit report
directly from the credit reporting agency or through an organization
authorized to provide credit reports to consumers.
Types of Credit Use Tips
- Apply for and open new credit accounts only as needed.
Don't open accounts just to have a better credit mix - it probably won't
raise your score.
- Have credit cards - but manage them responsibly.
In general, having credit cards and installment loans (and paying timely
payments) will raise your score. Someone with no credit cards, for
example, tends to be higher risk than someone who has managed credit cards
responsibly.
- Note that closing an account doesn't make it go away.
A closed account will still show up on your credit report, and may be
considered by the score.
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- Facts & Fallacies
- Learn the facts behind the common misconceptions about credit scoring.
Fallacy: My score determines whether or
not I get credit.
Fact: Lenders use a number of facts to make
credit decisions, including your FICO score. Lenders look at information such
as the amount of debt you can reasonably handle given your income, your
employment history, and your credit history. Based on their perception of this
information, as well as their specific underwriting policies, lenders may
extend credit to you although your score is low, or decline your request for
credit although your score is high.
Fallacy: A poor score will haunt me
forever.
Fact: Just the opposite is true. A score is a
“snapshot” of your risk at a particular point in time. It changes as new
information is added to your bank and credit bureau files. Scores change
gradually as you change the way you handle credit. For example, past credit
problems impact your score less as time passes. Lenders request a current
score when you submit a credit application, so they have the most recent
information available. Therefore by taking the time to improve your score, you
can qualify for more favorable interest rates. See
how improved scores can lead to savings.
Fallacy: Credit scoring is unfair to
minorities.
Fact: Scoring considers only credit-related
information. Factors like gender, race, nationality and marital status are not
included. In fact, the Equal Credit Opportunity Act (ECOA) prohibits lenders
from considering this type of information when issuing credit. Independent
research has been done to make sure that credit scoring is not unfair to
minorities or people with little credit history. Scoring has proven to be an
accurate and consistent measure of repayment for all people who have some
credit history. In other words, at a given score, non-minority and minority
applicants are equally likely to pay as agreed.
Fallacy: Credit scoring infringes on my
privacy.
Fact: Credit scoring evaluates the same
information lenders already look at - the credit bureau report, credit
application and/or your bank file. A score is simply a numeric summary of that
information. Lenders using scoring sometimes ask for less information - fewer
questions on the application form, for example.
Fallacy: My score will drop if I apply
for new credit.
Fact: If it does, it probably won't drop much.
If you apply for several credit cards within a short period of time, multiple
requests for your credit report information (called “inquiries”) will
appear on your report. Looking for new credit can equate with higher risk, but
most credit scores are not affected by multiple inquiries from auto or
mortgage lenders within a short period of time. Typically, these are treated
as a single inquiry and will have little impact on the credit score.
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Your credit report shows the information you have on file at one or all of
the three major credit reporting agencies - Equifax, Experian and TransUnion.
Each of these reporting agencies (also known as credit bureaus) maintain their
information separately, so the data you have on file may differ between them.
