How Credit Ratings Works: Understanding Credit and Your Credit Score

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Financial Freedom

Your credit score or also known as credit rating, is one of the most important parts in building a solid financial foundation. Learning about the factors that affect your credit rating can help you take steps to get a great credit score to help with things like:

•Securing low interest home and car loans

•Getting the best insurance rates

•Qualifying for a rental property

•Landing that dream job

By knowing the ins and outs of credit reports and credit scores, you are one step closer to financial stability and getting the things in life you need and want.

What is the difference between credit rating and credit score?

The phrases credit rating and credit score may be used interchangeably. Credit rating is usually in reference to a business or government agency’s creditworthiness and is often a letter grade.  A credit score is usually a number used to demonstrate an individual’s ability to pay back a debt. While it’s good to know that there can be a difference between the two terms, in many cases today credit rating and credit score are sometimes used conversely.  




Different credit score from each bureau

What is a credit score?

A credit score is a three digit number generated by a mathematical algorithm. There are a variety of these complex formulas  out there but they all take into consideration things like credit history, amount owed, payments made, new credit, and types of credit used.

Your credit score is crucial for you to get financing, whether you want to open a credit card, get a car loan, or mortgage a home. Your credit score helps determine whether you get the loan in the first place and at what interest rate you will be charged for borrowing the money. It also shows your reliability and determines if you will be able to rent an apartment, borrow a car, obtain a good insurance rate, or get that job you want. Ultimately, this magic number provides providers a quick and fair way to evaluate risk.

How did credit scores come to exist?

Before credit scores came about, banks and lenders had to physically review each individual applicant’s credit report to determine if they would grant the loan. If you’ve ever seen a credit report, there are lots of details including outstanding accounts including:

  • Types of debts (auto loan, credit card, mortgage, etc.)
  • The date the account was opened
  • Your credit limit
  • The account balance
  • The payment history

This time-consuming process of reviewing and evaluating the information would often lead to errors or even biased decisions because it was based on the lender’s interpretation.  

Over the past century, credit reporting and scoring has evolved for the better. Banks and other providers give credit information to numerous credit bureaus. In turn, the credit bureaus keep record of all your debts and payments via banks and lenders as well as the information obtained by public records. Credit scoring agencies then provide the interpretation of your credit information by formulating the data into a number or score.

While these bureaus and agencies were established with the intent to protect lenders they also benefit, you, the consumer. By capturing your financial behavior and reporting this to lenders, the credit bureaus and agencies directly impact your financial options. If you behave well financially, you benefit.

Who are the 3 major credit bureaus and how do they work?

Knowing about credit bureaus can help you understand your overall credit. Credit bureaus, also known as credit reporting agencies, collect information about your financial behavior. They compile your credit report and distribute the report to lenders, businesses, and consumers who request it.

While there are many credit bureaus, the three largest ones used by most lenders are:

These three major bureaus are independent of each other. They actually compete to capture, update, and store credit histories and produce valuable credit reports for which they charge money. Then, banks, lenders, insurers, potential employers, landlords, and consumers like you all may request these reports to determine your creditworthiness and reliability.

Three  ways credit bureaus collect your information:

  • Each month, banks, and lenders update one or more of these bureaus about your loans including how much owed and whether you make your payments on time.
  • Whenever you apply for a credit card or a loan, all of that information you put on the application is also sent to the credit bureaus.
  • The credit bureaus also scour public records for financial information, including court records from bankruptcies, foreclosures, and tax liens.

While knowing about the three major credit bureaus is vital to building your financial foundation, be aware there are dozens of smaller,  regional and industry-specific credit bureaus. Depending on the purpose of the credit report, these niche credit bureaus may be used to obtain more specific financial data.  

Who are the credit scoring agencies?

Just like there are multiple credit bureaus, there are multiple scoring agencies too. While these agencies utilize the credit bureau data, they formulate a mathematical score. The most common models are:

The FICO credit score system is owned by a data analytics company originally called the “Fair, Isaac and Company” which was founded in California in 1956. According to FICO, 90% of top lenders use FICO Scores. This system calculates a three-digit score which is kind of like a batting average for credit. The higher the number, the better.

The newer credit scoring model is called VantageScore. This was created by the three agencies, Equifax, TransUnion, and Experian to create a more consistent and accurate way to evaluate your credit risk and to create your credit score. Again, the higher your score, the better!

What are the different types of credit scores?

Each credit bureau and agency have their own scoring formulas. The higher the number  the better your credit score is.

  • Experian: 330 – 830
  • Equifax: 300 – 850
  • TransUnion: 300 – 850
  • FICO: 300 – 850
  • VantageScore: 501 – 990 (often assigned a letter grade, A – F)

Some reasons why your scores across the bureaus,  FICO or VantageScore are different from one another.

  1. The source of information

Each of the major credit bureaus keep track of your transactions and as such maintains such information. Sometimes, certain loan types are not reported on each bureau’s report. Also, the timing of data uploads can affect what information is included on reports.

2.  Your score is not consistently formulated  

Each credit score calculation by the credit bureaus and the scoring agencies may be weighted differently. These different calculations may produce a different score.

What makes up a credit score?

Credit score is calculated using factors including:

  • Payment history
  • Amounts owed
  • Credit history
  • New accounts
  • types of credit

This is why how you behave financially is so important. Every single time you make a purchase on a credit card or other loan, it will impact your credit score. And, every payment you make on time is crucial to keeping your score at its highest.

How is a credit score calculated?

how credit is calculated

While different bureaus and scoring agencies have different formulas to determine your score, we will go over FICO’s guidelines as they are the biggest influencer for most lenders.

Payment History – The biggest factor to calculate your score is your payment history. Paying on time weighs in for 35% of your score. No more missing payments! Not even one. This could lower your score substantially.  

Amount Owed – Another important factor that is used to calculate your credit score is what you owe. It’s a whopping 30% of your overall score. If you borrow too much money that is loaned to you, it appears you don’t have enough money to keep up with life expenses. Also, because your balance is reported to the bureaus separately from the payments you make, avoid racking up large balances. In other words: Don’t max out your credit cards!

The bureaus measure what you owe by using what’s called a “credit utilization ratio. This is financial talk for your total outstanding debt balance divided by the total amount of available credit. You’ll want it to be under 30%.

Credit History – Another consideration used to calculate your score is your credit history and if you are opening new lines of credit. This credit history accounts for 15% of your score. In order to feel comfortable loaning you money, banks would like to see a long, consistent history of using credit. In other words, you are responsible financially.

New Credit – While the older your accounts are affects your score for the better, you don’t want to have too many accounts opened within a short period of time either. Not only will this lower the average age of your credit accounts but may put up a red flag that you are desperate for more credit. New credit makes up 10% of your credit score.

Tip: If you’ve applied for a credit card and are denied, it is best to to wait a  bit. Try to improve your credit by making consistent payments to lower balances. Then you can try applying again just as long as you are allowing some time to pass after the denial.

Credit Mix – This makes up for the last 10% of your score. It’s best if you have multiple different types of loans instead of just a single type.

What are good and bad credit scores?

While there is some variations, generally here is the breakdown of scores.

Good and bad credit score meter
  • 750 – 850 – Excellent – You’ll get the lowest interest rate if your score falls in this range.
  • 700 – 749 – Good – Approval chances are high.
  • 650 – 700 – Average – Approval is harder and the interest rate will be high.
  • 300 – 649 – Poor – Approval chance is low.

What hurts my credit score?

While it’s important to know what can help your credit, knowing what can harm your credit score is just as important. Knowing what may lower your credit score empowers you to take control of your financial future.

Paying late or not at all

Even being late on one payment will seriously affect your score. And paying nothing is even worse. When you miss a payment, creditors can opt to charge your account off. More on that below.

Having your account charged off

When a lender believes you are not intending on making payments to your account, such as the case when you don’t make a payment, they can “charge off” or “write off” your account.

Collections

If a creditor uses a third-party collector to try to attain payment, this is considered as being in collections. Sometimes this last effort to collect payment happens prior to the account being charged off. This too, is not what you want to happen.

Defaulting on your loan

Similar to charge offs is defaulting on your loan. This means you have somehow not fulfilled the terms of your loan, such as repayment.

Filing for Bankruptcy

This is a serious action on your part to state you are unable to make payments on loans. Filing for bankruptcy stays on your credit report for 7 years and should be a last resort. Getting behind on mortgage payments

When you can’t pay your home loan, you foreclose on your home. This is detrimental to your credit score and hurts your ability to get loans in the future.

Court judgements

If you’ve been unable to payback your loans, a lender may take you to court in order to receive payment. All judgements are disadvantageous to your score. But paid judgements are better than unpaid judgements.

High or Maxed Out Balances

The most damaging thing you can do is carry a high or over the limit balance since this is the most important factor in your credit score.

Closing Cards

Cancelling your cards can hurt your credit from both a credit utilization and length of credit history standpoint. Keep your old cards and your paid-off cards open.

Too many credit card applications

Avoid applying to new credit cards too frequently. It appears desperate and not responsible.

Having only one type of credit

Credit cards are considered one type of credit, known as revolving credit. If you only have one type of loan on your credit report, it is not as favorable.  

How do I improve my credit score?

Avoid late or delinquent payments.

If your creditor, puts you in collection status, it will have a serious impact on your score.

Work to pay off debt

While sometimes transferring balances from one lender to another is a wise decision based on interest rates, it is best to try not to move your money around too much. Once you’ve paid off a creditor, remember don’t close the account.

Avoid applying for additional credit

You may read that opening additional credit accounts may help you have a better “credit mix”. On the contrary, opening too many accounts may not be good for your score. Only apply and open new accounts as you need to.

Keep debts low as possible

If you are unable to pay off debts, work to keep them as low as possible. High debt is unfavorable.

What are the different types of credit inquiries?

When a someone requests a credit report or score, it is called a credit inquiry. Credit inquiries help a bank make a decision if you are worth the risk of loaning you money. When you apply for a new credit card or a new loan, the lender will make a credit inquiry on you and your credit score is revealed. While credit inquiries are a small part of your credit report, you’ll want to be aware of what credit inquiries are occurring and monitor your credit report.

A credit inquiry can be either soft or hard. Depending on why the credit check is being done and who is requesting it, the credit bureau or agency will determine how to weigh the credit check.

What are soft credit inquiries?

Soft credit inquiries, as its name implies, is not as intense as hard credit inquiries. They are informal and can happen without your permission, and they do not impact your credit score.

This type of credit pull is usually done by lenders to prequalify you for a certain loan, when you check your own score, or even an employer may use this type of credit inquiry to understand your financial history. Sometimes, a soft credit inquiry is done to rent a car or an apartment, or verify your identity when you open a savings or checking account.

What are hard credit inquiries?

Hard credit inquiries, on the other hand, remain on your report and affect your score. It is an impactful inquiry on your financial history. These inquiries are made once you approve a lender to do so, such as when you apply for a business loan, auto loan, student loan, mortgage, or other lines of credit. Sometimes hard credit inquiries can be made when you rent a car, an apartment, apply for a cell phone contract, open a savings or checking account, or request to have your credit limit increase. Knowing this will allow you to know what’s happening. Good thing, right?

Most hard credit inquiries come from banks, credit card issuers, and other major financial institutions. Whether your approved or not, makes no difference. The hard credit inquiry remains on your report for up to 2 years and can affect your score for up to 12 months. How does this affect your report and score, you ask?

A few hard credit inquiries won’t significantly hurt your score. But lots of hard credit inquiries within a short period of time can seriously damage your score. But don’t stress. Not all hard credit inquiries are the same. Credit bureaus and agencies consider the circumstances of the hard credit inquiry and what kind of credit history you currently have. This is fortunate if you are being a smart cookie and shopping around for the best loan. If you apply for the same type of credit account from multiple lenders within 30 days, often these credit inquiries are treated as just one hard credit inquiry.

How do I get my credit score?

Because of the Fair Credit Reporting Act in 1971 and continuous updating of government legislation, we have access to our credit reports and scores from each of the three credit bureaus: Experian, TransUnion, and Equifax. You can get a free copy every 12 months, per the law, as well as at any point you are denied credit. Currently, the only authorized source for your free report is AnnualCreditReport.com or 877-322-8228. Your credit report is the data from which your score is calculated. Your report will not have your score on it.

To obtain your credit score, first, peek at your credit card statements as some have opted to include this information for you. If not, you will need to purchase directly from one of many service providers, the three major credit bureaus or other credit score provider, such as FICO. Recognize that depending on the sources of your score, credit scores can vary. But checking is wise periodically or prior to a big purchase like a mortgage.

Why should I monitor my credit score?

Certainly you now know how important your credit score is. Regular monitoring is a must to improve and maintain your score. We know life’s busy but here’s why you need to keep tabs on your credit score.

You were denied credit

Nowadays, it is common to apply for many different  credit cards for reward points, to get the best deal at your favorite retail store or to take advantage of big discounts on purchases If you applied for a credit card and were denied credit, you are entitled to see the credit report used by the lender to evaluate your application. Because of the various credit agencies, you should receive the specific agency’s report. Refer to the rejection letter from the bank to determine how to attain such report. You must request this report within 60 days of the denial.

While sometimes stressful to see these rejections, it’s important you understand it. It may be an error that you can remedy. If not, you can learn what you need to do to improve your situation: make more consistent payments, lower your debt, etc.

You cosigned a loan

If you’ve made the choice to help out a family member or close trusted friend and cosigned a loan, it’s vital you pay attention to your credit report. If this person misses a payment or is habitually late, this information will appear on your report. By monitoring your report you will be able to respond quickly to any problems. Don’t assume or take someone’s word for it. Check your report.

To keep an eye out for Identity Theft

Don’t be a victim. While sometimes you can’t prevent someone from hacking your account or stealing documents or information, you can take steps to remedy it and the sooner the better. If your identity is stolen, your credit score will plummet. Despite your best efforts to prevent it, you are not invincible. If it does happen, it will take months of dispute to repair the damage.  Best to monitor each year or even consider a service that checks your report daily.

You plan to apply for a loan in the future

So this reason seems obvious. If you are thinking about a new loan, whether it’s a mortgage loan or car loan,you should check your credit before. Know what information is on your credit report before the bank does. Remember to look at account payments (look for late or collection accounts), high balances, and your credit score. Consider these against the probability of your loan being approved. Resolve any problems before you apply for a loan and shop banks and research them before applying so that you have limited credit inquiries. Remember each credit application lowers your credit score.

So how often do you check your credit, you ask? It is recommended to inquire on your report every 12 months. Mark your calendar today or consider a service that monitors your credit for you. Also, because each of the major credit bureau maintains their own information, it is smart to check each agency’s report each year.

How do I fix an issue with my credit report?

If you notice something in error on your credit report, you can dispute it. After getting  a copy of your credit report, determine which creditor has the incorrect information. Contact them directly. Alternatively, you can contact the credit bureau to get more detailed information or to file an official dispute.  

Couple reading their credit report.

Take Action to Increase your Credit Rating

Start today and review your credit reports and determine your credit score. Resolve any problems and take the necessary steps to improve your financial foundation. Remember that your score will fluctuate throughout your life, but now you know which factors are influential in determining your score. You can make wise decisions and provide yourself a life full of opportunities as your credit score rises. With some simple steps and a good understanding of how credit works, you can continue to build steps to financial freedom!