Credit Scores Explained

Have you noticed how many advertisements there are these days that have to do with personal credit? On the radio as you drive to work, on television as you are falling asleep, in the newspaper, magazines and on the websites you like to visit – you just can’t get away from them. Personal bankruptcy attorneys, credit counseling agencies, “free” credit reporting services and a host of variations on the above – we are bombarded by these ads daily, just about everywhere we look. And the reason for this is simple: there is a crisis with credit in America.

By some estimates, over 30 million Americans have “poor” or “extremely poor” credit ratings – and as we start out 2008, this number is likely to continue to grow. There are many factors that have contributed to this in the last decade, but the bottom line is that if you have been turned down for a mortgage, personal loan or credit card recently because of a poor credit score, you are not alone. There are millions upon millions of people in exactly the same situation as you are and if you are like most of them, you have no idea how to even start to do something about it.

The first step to understanding and addressing poor credit is to understand what your credit score is, how it is determined, and how it is used.

What is a credit score?

Simply put a credit – or FICO – score is a mathematical equation which uses information from your credit report and other sources to help lenders determine your credit worthiness. In most cases, FICO scores are calculated by lenders and other authorized parties using information obtained from the three major credit reporting agencies: Equifax, Experian, and TransUnion – who may also calculate a credit score and provide it to lenders upon request. It is important to understand that your FICO score may be different – and sometimes significantly different – at each of the three major credit reporting agencies. This is because each credit reporting service uses only the information they have when determining a FICO score. If the information differs between the agencies, an individual’s credit score as calculated by that agency will differ. It should be noted that derogatory information – such as late payments – will usually stay in a credit report, and therefore affect a credit score, for seven years. Bankruptcy, judgments and loan defaults can affect a credit score for up to ten years.

How is a credit score determined?

There are a number of factors which are used to determine an individual’s FICO score, and each of these factors is given a different value in the actual determination of that score. By and large, the most important factors used to determine an individual credit score will include:

• Payment history
• Outstanding debt
• Length of credit history
• Severity and frequency of derogatory credit information such as bankruptcies, charge-offs, and collections
• The amount of credit used compared to the credit available

Each of these factors are given a numerical value, and then plugged into a set mathematical formula to determine the final credit score.

It is important to understand that credit scores are considered to be “fluid” in nature, as opposed to, say, a fixed interest rate on a loan, which is considered “static” in nature. FICO scores are considered fluid because the information in a credit report is continuously reviewed and updated by the credit reporting agencies. This means that what an individual’s credit score is in March may very well not be the same as what it is in September. Based on what happens in those six months – or any other period of time – the FICO score can go up or down. To use just one simple example, six months worth of on-time loan payments will very likely push your credit score up a few points, while six months’ worth of late payments will have exactly the opposite effect. Again, it is important to remember that since not all lending institutions report customer information to each of the three credit reporting agencies, any changes to an individual credit score has the potential to vary from agency to agency.

Who can see a credit score and what is it used for?

The Fair Credit Reporting Act (FCRA) defines who can and cannot see your credit report and credit score. Businesses must have a "legitimate business need," and a "permissible purpose," as stated in the federal law to obtain any information contained in your credit file, including your FICO score. Otherwise, only those who you give written permission to are allowed access to the information in your credit files. By law, any individual is allowed one free copy of their own credit report from each of the three major credit reporting services every year.

Some examples of those who can access your credit files include:

• Credit Grantors
• Collection Agencies
• Insurance Companies
• Employers

Credit reports – and the credit scores that they are used to help generate – are used in a variety of ways by those that have access to them. Broadly speaking, however, credit scores are one of the factors used by lenders to determine an individual’s credit worthiness – or, put another way, the risk that a lender can expect to incur by making a loan. The higher a credit score is, the more likely an individual is to be approved for a mortgage, auto loan, or credit card. Additionally, credit scores are also used in determining the rate of interest the lender will be willing to extend credit at. In general, the lower a credit score, the higher the interest rate can be expected to be if, indeed, the loan is approved.

Can a poor credit score be improved?

The good news is that a poor credit score can be improved. The bad news is – they don’t make it easy. Even flawed or incorrect data can be difficult to get removed from a credit report, and can therefore continue to negatively impact a credit score until it is expunged. Some things that you can do immediately to positively impact your credit score include:

• Make at least the minimum payments to all loans – including mortgage, auto and credit cards – on time every month.

• Pay down the balance(s) on your credit card(s) – one of factors used to determine a credit score is the percentage of available credit actually used.

• Avoid applying for additional credit “just to have it”.

• When possible, pay “cash” (money, check or debit card) for purchases to help keep monthly credit balances as low as possible.

One of the major challenges that many people face when attempting to improve a poor credit score are things that have happened one, two, even five years in their past, or longer. Remember that most derogatory information will remain on a credit report for seven, and sometimes even ten, years unless it is addressed. While these derogatory marks on a person’s credit can be extremely difficult to repair, during my fifteen years as a mortgage broker I have worked with hundreds of people and helped them add 50, 100 even 200 points to their credit score – and so I know first hand that it can be done. If you would like to get a better idea of what is involved, and how you can raise your score, come to my website at www.afreshstart.com, and I will give you a free credit repair kit to help you get started.

Credit scores and credit reports might seem confusing, but in reality they are really only information and mathematics. The first step towards taking control of – and improving – any credit score is understanding what it is and how it works. After all, the most important weapon you can have in your financial life is knowledge!