Your Credit Reputation
Part of everyday life involves managing your finances. This
could range from administering an investment portfolio to clipping coupons.
Yet very few people take the time to manage a very important part of
their financial situation – their credit reputation.
Your credit reputation – your experience in borrowing
money – will impact the interest rate you pay on any type of loan - real
estate loans, car loans, credit cards, installment loans, and so on. In
addition, many insurance companies are now using your credit to determine the
premium you pay on property insurance and auto insurance. A person with a poor
credit reputation will pay thousands of dollars more in interest payments and
insurance premiums than a person with a good credit reputation.
Is Your Credit Information Correct?
The first step in managing your credit reputation is making
sure the information in your credit file is accurate. This involves obtaining a
credit report. There are three credit repositories in the USA that maintain
credit information – Experian,
TransUnion, and Equifax. Most of the information they receive comes from
creditors who report information to the repositories. Because not all creditors
report to each of the three repositories, it is a good idea to obtain a separate
credit report from each repository.
An additional benefit of obtaining your credit report is
spotting “identity theft”. As this becomes more common, reviewing your
credit file on a frequent basis is a must. And if you are an identity theft
victim, finding the theft early is the best way to stop this event from getting
out of hand.
There are numerous ways to obtain a credit report. The
fastest and easiest way is to simply go to the websites of the credit
repositories. Using this method will involve a total cost of around $35 to
obtain reports from all three repositories.
Another way to obtain a credit report – which is free – is to call the repositories. Colorado is one of a handful of states where the credit repositories are required to provide Colorado residents with one copy of their credit report each year at no charge. The automated phone service will ask that you provide personal information – name, social security number, address, etc – so the repository can confirm your identity. You will receive the report in 2-3 weeks. The phone numbers to call are as follows:
§ TransUnion - 800-916-880
Equifax - 800-685-1111
Experian - 888-397-3742
Once you have obtained your credit report, there are two
areas within the report to review carefully. First, look to see if there any
derogatory items (late pays, collection accounts, etc) that are incorrect.
Second, review the report for any open accounts that do not belong to you. You
should ignore items on the report such as the high balance, current balance, and
payment amount, unless they are significantly inaccurate. Also, do not be
concerned with previous address information or employment information, as this
data is not used by anyone in determining your credit reputation.
If you do have incorrect derogatory information, or an open
account that does not belong to you, you will need to “dispute” the
inaccurate information with the repository. The credit report you receive will
most likely include a form that you can complete and return. Or you can write a
separate letter and send this to the repository. It is usually best to send the
form or letter via certified or registered mail.
If you do decide to write a separate letter, there are three key items to put in your letter.
Once the repository has received the form or letter disputing the information, the repository will contact the creditor in question to confirm the accuracy of the dispute. Unfortunately, under the law, the creditor has the final say as to the accuracy of the information. So if the creditor states the information is accurate, it will stay in your credit file. Regardless of the result, the repository is required by law to respond to your dispute within 30 days.
Be forewarned – correcting mistakes in your credit file could be a very time consuming and frustrating process, especially if you no longer have a relationship with the creditor. But given the financial benefits, it will be time well spent.
A credit score is the numeric value of your credit reputation, with the higher the score the better the credit reputation. A credit score takes all the information in your credit file and assigns it a 3 digit numeric rating. Credit scores will range between 300 and 850, although it is rare to see scores below 400 and over 825.
Long before credit scores, human judgment was the sole factor in analyzing an individual’s credit. Lenders used their past experience at observing consumer credit behavior as the basis for judging an applicant. Not only was this a slow process, but it was also unreliable because of human error. In addition, the process was not objective or consistent.
Credit granting took a huge leap forward when statistical models were built that considered numerous variables and combinations of variables. These models were built using payment information from thousands of actual consumers, which made credit scores highly effective in predicting consumer credit behavior.
Credit scoring has been in existence since the 1950s, and credit scores have been widely used by retail merchants, credit card companies, and other non-mortgage lenders since the 1980s. The use of credit scores for mortgage loans began in the mid-1990s, and almost all mortgage lenders now use credit scores in some fashion.
The original credit score model was developed by the Fair Issac Company – thus credit scores are often referred to as “FICO scores”. Each of the three credit repositories – Experian, TransUnion, and Equifax – have their own scoring model, thus each person really has 3 credit scores. Because all these scoring systems are based on the FICO model, the three scores should be fairly similar.
The following is the distribution of FICO scores across
Lenders use credit scores to tell them how likely potential borrowers will pay back their loans, and thus use credit scores to determine whether or not to grant credit, and at what interest rate. The higher the score, the lower the risk. And lower risk to the lender generally translates into a lower interest rate.
The importance of the credit score to the lender will vary depending upon the type of credit being sought. For example, credit card companies use credit scores almost exclusively when analyzing an applicant, and will generally not concern themselves with the applicant’s income, employment, or assets. For mortgage loans, credit is very important, but mortgage lenders will also consider income and assets in the qualification of a consumer.
How Credit Scores Are Calculated
Credit scores are calculated from a lot of different data in your credit file. This data can be grouped into five categories, and each of the categories will have varying importance in determining your score, as follows:
Payment History - 35%
Amounts Owed - 30%
Length of Credit History - 15%
Types of Credit - 10%
New Credit - 10%
These percentages are based on the importance of the
five categories for the general population. For particular groups - for example,
people who have not been using credit long - the importance of these categories
may be somewhat different.
Payment History includes the following items:
Amounts Owed takes into consideration these data elements:
of Credit History
includes such factors as the time since accounts were opened and the time since
last account activity.
Types of Credit is the number of (presence, prevalence, and recent information on) various types of accounts.
It is important to remember that a credit score takes into
consideration all these categories of information, not just one or two. No one
piece of information or factor alone will determine your score.
It impossible to say exactly how important any single factor is in determining your score - even the levels of importance shown here are for the general population, and will be different for different credit profiles. What's important is the mix of information, which varies from person to person, and for any one person over time.
Improving Your Credit Score
As you start the process of improving your credit scores you must remember that the importance of these five factors depends on the overall information in your credit report. For some people, a given factor may be more important than for someone else with a different credit history. Thus the steps you need to take to improve your credit score may be totally different than someone else.
Also, improving your
credit score has been compared to losing weight – it takes time and there is
no quick fix. This is especially true if you have had delinquent accounts.
Even though the
improving of one’s credit scores is truly unique to each individual, the
following actions would apply to most consumers:
Credit Scores and Mortgage Loans
The use of credit scores for mortgage loans is fairly new. Prior to the mid-1990s, mortgage lenders rarely used credit scores. In 1993, the Federal Home Loan Mortgage Corporation (Freddie Mac) was the first to incorporate credit scores into their mortgage loan underwriting process. Almost all mortgage lenders now use credit scores in some fashion.
While each mortgage lender uses credit scores differently, the following is generally the way most mortgage lenders rate an individual’s credit based on credit scores:
Prior to the acceptance and use of credit scores, credit was just one factor in the mortgage loan qualification process. Other factors that were considered equal in weight to credit were the debt-to-income ratios (the relationship of monthly income to monthly debt payments), employment history, downpayment/equity, and liquid reserves. Through the analysis of the performance of millions of mortgage loans, lenders have learned that an individual’s credit reputation – as evidenced by their credit score - is the most important factor in determining how consumers will repay their mortgage loans.
As a result of credit scores, the mortgage industry now categorizes mortgage loans into 2 broad categories – “prime” and “sub-prime” mortgage loans. Generally speaking, a borrower with a credit score of less than 620 falls into the sub-prime category. To reflect the risk associated with people with poor credit, sub-prime loans have a higher interest rate than prime loans, and require a larger downpayment/equity position.
The embracement of credit scores by the mortgage
industry has resulted in many positive changes for consumers.
© 2000 Reed
Mortgage Corporation. All rights reserved.