By Tom Alessi, Chief Credit Officer
Credit scores are very important in our society. They can affect your ability to get loans and credit cards, insurance, an apartment or maybe a job. They have evolved into a proxy for your character.
So, can you name the credit reporting agencies that provide your potential creditors with important information that could determine whether they should lend you money? Interestingly enough, most people in this country can’t. Most people know they have a credit score, but do not know how that credit score is calculated or what it might mean.
Do you have a credit card? Auto loan? Home Equity loan? Mortgage? If you do, it is likely that your lender (the credit card company, bank or mortgage company) is reporting your payment performance on those borrowings to a credit reporting agency.
Credit Reporting Bureaus
There are three major credit reporting bureaus: Experian, Equifax and Trans Union. All three of these agencies use complex, proprietary mathematical algorithms to turn the mass of data reported into the all-important numerical “score” by which creditors judge. Each of the agencies has a slightly different method of calculating the score, but the basics are the same. They all accumulate certain data that is reported and feed it into their proverbial black box for processing. To understand the credit score, it is important to understand what information is used to calculate it.
Financial Statement Basics
If you were to talk to traditional lenders about what information they would consider before lending to someone, after they extolled the virtues of knowing a borrower’s “character,” they would take you through the basics of a financial statement. Starting with the balance sheet, they would want to know the borrower’s assets, liabilities and resulting net worth. Assets are things that you own. Liabilities are things that you owe. After all, doesn’t it make sense that someone with many more assets than liabilities (a positive net worth) would have a better chance of making their payments on their loans than someone who has more liabilities than assets (a negative net worth)?
That traditional lender would also want to see income and expenses that would result in positive net earnings to further support the borrower’s net worth. Again, doesn’t it make sense that someone who has more income coming in than expenses going out would have a better chance of making loan payments than someone whose expenses exceed their income?
Surely a person would think that winning a million dollars in the lottery would make it more likely that they can make their loan payments and, thereby increase their credit score. Surely, a person would think that by getting a big raise or a bonus that their credit score would be improved. Surely a person would think that losing a large sum of money at the local casino would cause their credit score to go down.
You might think that all of those considerations would affect your credit report and score. But that is not how the credit reporting agencies evaluate the risk of creditors getting paid. In fact, the only aspect of your financial information that is considered in your score is a portion of your liabilities; only the portion that are reported to it by your creditors. Your credit report and score only reflect your payment performance on the credit cards and loans you have with creditors who report to the credit reporting agencies. Your payment performance on the boat loan that Uncle Joe gave you will not be included. Your payments on the mortgage that Mr. and Mrs. Doe gave you when you bought the Ocean City condo from them also will not be included. It’s a very narrow sliver of your overall financial situation.
Reporting Agency Factors
These agencies are predicting your future payment performance by analyzing specific factors determined by them to be an indication of whether you will repay your obligations in the terms you have agreed to with the creditor. The reporting agencies are looking at the factors that follow:
- Do you pay your creditors on time?
- How much you owe them?
- How many of them you owe?
- How long have you had accounts with them?
- What kind of debt do you owe them (revolving or term debt)?
- How many other potential lenders are checking your score because they might make new credit available to you?
- Are there public records filing against you (collections, judgments, foreclosures, bankruptcy, etc.)?
So what does that mean? It means that you can improve your score by doing specific things that would make the data being provided to the reporting agencies look better. Those things are as follows:
- Make when due all credit card and loan payments to creditors who report to the agencies.
- Keep the balances on those obligations as low as possible.
- Keep the number of creditors who report to the agencies to a minimum.
- Keep your accounts from going to collection.
- Keep the inquiries from new creditors limited to as few as possible.
- Check your credit report periodically.
Free Credit Report
You can obtain a free copy of your credit report from each of the three credit agencies one time per year. If you would like to order your report from all three of the agencies, you can order all of them at one time or space them out during the year. The free reports will not include your score and will not impact your score. If you want the score, you will have to pay a fee. However, you should check your credit report to make sure that it is complete and accurate.
There are several avenues to access your free reports. You can go to annualcreditreport.com on the internet, call 1-877-322-8228 or mail an Annual Credit Report Request Form which can be accessed through the Federal Trade Commission’s website at www.consumer.ftc.gov. If you have any questions about credit reporting, please call me at 410-871-9770.