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What is Credit? A Crash Course on Credit Scores

August 7, 2017 • Steve Cyr • Tags:

 

Seriously, what is credit?  As an adult, you might feel like everything you do financially revolves around some mysterious, mystical number, but what does it all mean?  We’re going to take a look at credit scores, how they are determined, and where you can go to learn more about yours!

 credit score scale

Let’s start with the basics. 

A credit score is a “statistical number which ranges from 300 to 850 that depicts a person's creditworthiness. The higher the score, the more financially trustworthy a person is considered to be. Companies generate a credit score for each person with a Social Security number using data from the person's previous credit history.

 

In simple terms, a credit score comes from your relationships with those who have loaned you money.  There are quite a few things considered when calculating your number.

Before we get into those factors though, we should talk about what credit scores are used for and who uses them.  Lenders, such as banks and credit card companies, use credit scores to determine who qualifies for a loan, at what interest rate, and what credit limits. Lenders also use credit scores to determine which customers are likely to bring in the most revenue. The use of credit or identity scoring prior to authorizing access or granting credit is an implementation of a trusted system.  Basically, your credit score is an effort to predict how likely you are to pay back the money you borrow.  Once creditors receive your score, they can then decide what type of financing they are willing to provide to you. 

Now back to figuring out your score.  According to www.myfico.com, there are five key factors involved in determining your credit score and each carries a different weight.

These factors are:

  1. Payment history
  2. Amounts owed
  3. Length of credit history
  4. New credit
  5. Types of credit used

Note that by way of the Equal Credit Opportunity Act (ECOA), your race, sex, marital status, national origin, or religion are not determining factors in your score.  FICO considers each of these items listed above and then creates a score from the information provided.  But where does this information come from?Credit score percentage breakdown

The three credit reporting agencies that are relied upon most and collect financial information from you to send to FICO are Equifax, Experian, and TransUnion.  This means you actually have three FICO Scores, one for each of the bureaus.  What’s even more interesting about this is that the scores can be different depending on a few different variables.  Each bureau operates independently from the others and have their own evaluation and reporting methods.  What may show up on one credit report might show up differently or not at all on another.  But how do finance companies determine which score to use?  It’s up to them!  The score a creditor uses when evaluating the risk in lending to you depends on their preference in methods and reporting as well as their relationship with the credit reporting agencies.  You can dive deeper into how each firm determines your credit score at www.myfico.com, www.experian.com, www.transunion.com, and www.equifax.com.

Now that you have an answer to the question, “What is credit?” Let’s talk about where we can find your score.  The first thing you need to know is that under the Fair Credit Reporting Act (FCRA), you are legally entitled to a free copy of your credit report once every 12 months.  The only website authorized to fill orders for this free report is www.annualcreditreport.com.  According to the FTC, a credit report includes information on where you live, how you pay your bills, and whether you’ve been sued or have filed for bankruptcy.  Note that a credit report DOES NOT include your score, but it includes the information that is used when determining your score.

Finally, if you want to access your actual score as determined by information provided by Equifax, Experian, and TransUnion, you will have to purchase it from the reporting companies.  They are allowed to charge a reasonable fee for the score, which is also usually accompanied by information on how you can improve it.  Fees for your scores can be found at each of the bureau’s respective websites.

So there you have it.  We now know what credit is, how it is determined, and how to discover what yours looks like; you can take it from here!  It’s is highly recommended that you educate yourself on your credit both to know where you stand financially and to be aware of any fraudulent or unknown activity happening (hopefully there is none!)  Being familiar with your credit report and what creditors are seeing will enable you to better understand the options you have and make you more empowered as a consumer.