How are Credit Reports and Credit Scores Calculated?
If you have ever applied for a loan, looked for an apartment to rent or wanted to get a cell phone of your own, you have probably been asked about your credit history. Just like a person’s reputation, your credit score indicates to others how well you pay your bills and handle your money. Think of it as a financial report card. It’s an important part of becoming a responsible adult.
A credit report is a written file that contains information about you and your loan payment history, including the current status of any credit accounts you have. The report also provides information on:
the amount of credit you have available to use
the current balances on debts outstanding
if your payments have been made on time
names of any companies you have credit with
the age of the credit accounts
types of accounts
information such as your name, current address, date of birth
public records such as bankruptcies, judgments, tax liens
Where Does This Credit Information Come From?
Information on a credit report comes directly from companies that have extended you credit in the past or from those with which you have open accounts. These companies include credit unions, banks, auto and mortgage lenders and retailers. The companies report monthly the details of your credit activity to one of the three major national credit reporting bureaus. Credit reporting companies (credit bureaus) then compile these reports.
The three major credit national credit bureaus are:
Lenders use these reports to help them decide if they will loan you money, the interest rates they will offer you, or to determine whether you continue to meet the terms of the account. Other kinds of companies can purchase reports to help inform them while making a wide range of business decisions such as providing or pricing insurance, renting you a residential property, providing you with cable TV, internet, utility, or telecommunication services, and (if you agree to let them look at your consumer report) making employment decisions about you.
Your credit report information is updated and changes every month and will follow you throughout your lifetime. If you regularly pay your bills on time, your creditors will report that positive information that will then reflect positively on your credit score. If you make payments late or miss payments, your creditors will report that negative information as well, which may lower your credit score.
What Makes up a Credit Score?
Fair Isaac Corporation (FICO) scores are widely used as the industry standard by lenders when reviewing loan risk. FICO scores range from 300 to 850, and the higher the number the better credit risk you are. The median FICO score is 720 out of a possible 850. On average, an excellent credit score is 750 and above; a good score is 700-749; a fair score 650-699; a poor score is 550-649; and below 549 is considered a bad score. Computer formulas used to calculate these scores are based on five different categories.
- Payment history has the largest impact at 35 percent of the total score. Payment history includes current and past delinquencies as well as public records. A lender’s main concern is getting repaid the money lent. If a person makes payments as stated on the loan agreement and on time, the score will slowly and steadily go up.
- Amounts owed reflect how much is owed on your accounts and how much of your total available credit is still available. Do you have different types of credit such as auto, mortgage, installment loans and credit cards? If so, how much is owed on these different loans? The software used for credit scoring compares a mix of different types of credit and whether they are managed responsibly.
- Length of credit history takes into account how long a person has been using credit, how old the oldest account is and what the average age of all accounts are. A longer credit history is better as long as payments have been made on time.
- New creditor looks to see how many new accounts a person has applied for recently and when the last time was. The score assumes that if a person has opened several new accounts in a short time span they may be experiencing cash flow problems.
- Types of credit used considers a mix of different credit types such as installment loans, store cards, credit cards and mortgage loans. It also looks at how may total accounts you have.
Our credit report and credit score will follow us throughout our lifetimes. It serves as a powerful tool for others to gauge our loan repayment ability and our character. Knowing how it works can help us make better financial decisions for our future.
Want a little more help? Check out our eLearning module on CREDIT SCORE AND REPORTS.