Credit Reports and Scores

You start laying the foundation of your credit history the first time you borrow.

There’s a vast—and constantly growing—amount of information about how consumers use credit. And you can be sure that when you apply for credit, whether it’s as routine as asking for a new credit card or as significant as applying for a mortgage, potential creditors will check out your credit history.

Making history

The three major national credit reporting companies—Equifax, Experian, and TransUnion—collect two types of information about you. The first is how you use credit, from how much you owe on car loans, mortgages, and credit cards to the timeliness of your monthly payments. There’s an incredible amount of data that falls into this category—about a billion items a month, which breaks down to an average of 11 items per credit user.

Credit reporting companies also store public information about you that might influence the way lenders evaluate your creditworthiness. This can include anything from records of bankruptcies and foreclosures to court judgments. But credit bureaus don’t gather any personal information that isn’t directly credit-related, such as how much you make, what you spend on rent or utilities, or anything you pay for in cash.

The companies make the information they’ve collected available—at a price—to creditors, banks, potential employers, landlords, and others who have a legal right to evaluate you based on your use of credit. Most information remains on your report for quite a while. Damaging activity can appear for up to seven years even if the account is closed or inactive. And bankruptcies can stay on your report for up to ten years unless the state where you live imposes a shorter limit.

Who’s keeping score?

Did you ever wonder why it takes a retail store or an online credit card company just a minute or two to approve your application for credit? Did you know that you may be quoted one interest rate on a car loan while the next person to apply is offered a higher—or lower—rate? These kinds of things happen because credit decisions often come down to the credit score you’re assigned by the credit reporting agency your potential creditor contacts.

All credit reporting agencies use a process called credit scoring, or credit modeling, to evaluate the risk you pose to a potential creditor. Your score depends on five main criteria:

• Your payment history, and specifically whether you pay on time
• The total amount you owe
• The length of your credit history
• The amount of new credit you have
• The types of credit you use

Creditworthy behavior in these categories works in your favor, while risky behavior works against you. And while there are general standards for the way the criteria are applied, there are no fixed rules. Credit reporting companies aren’t required to explain the way they arrived at your particular score, and you shouldn’t expect them to do so. All they are required to provide are up to four reasons for the score, which the lender must tell you if you ask why your application was denied.

What’s the score?

When you get a credit score, you’re going for a high number. Approximately the top 20% of reports that are evaluated get scores over 780, while the lowest 20% get scores under 620.

Each lender sets its own standard for what qualifies as an acceptable score, and determines the interest rate for which you qualify based on your score. The best rates—in this case, the lowest rates—go to applicants with the highest scores. Applicants with low scores, sometimes called subprime borrowers, may be offered credit at higher rates.

Credit scoring has its advocates and its detractors. Those in favor say that, in addition to the advantage of speed, lenders get a better picture of your creditworthiness with this timely snapshot. That, they say, makes the system fairer. Critics argue that reducing all the information about you to a single score can provide a distorted picture. They also say that a lender can find it easier to say no on the basis of what appears to be a value-neutral system.

What the lender knows

Lenders may go beyond your credit score in evaluating your application. For example, they may want to know the amount you earn, whether you’ve been at the same job for two years or more, and if you’ve lived at the same address for a while. In addition, lenders may be more willing to grant you credit if you already have banking or investment accounts with them.

Staying on top

Building a good credit history means developing good credit habits:

• Get a credit card and use it responsibly
• Make purchases every billing period, and pay them off in full and on time
• Apply gradually for additional credit

You can keep up to date on what the credit reporting agencies know about you by checking your credit report three times a year—once at each of the three major bureaus. It’s free. All you have to do is log on to www.annualcreditreport.com and follow the instructions. You’ll also find out how to correct errors or add explanations.

This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.