CHAPTER 6
The Credit System and How It Works
It doesn’t matter how good looking you are, what kind of car you drive, or how impressive your possessions. Your credit score doesn’t take any of this into consideration. There’s nothing sexy about credit, and looks are often deceiving. What does matter is what your score reveals—the conclusion that lenders, insurance companies, and employers draw about you is frequently based on inaccurate credit reports.
That’s not the exception; it’s the rule. A full 79 percent of all credit reports contain at least one error.5 This error rate is staggering. Imagine what you would think upon finding out that doctors misdiagnosed patients 8 out of 10 times. Or what if an NFL quarterback threw an interception on 8 out of every 10 passes? As Donald Trump would say, “You’re fired!” So why is it acceptable for 79 percent of all American credit reports to have at least one error? You see, the American credit system is broken and full of errors. But we all have to work within the system, or the system will beat us.
Over half (54 percent) have wrong demographics such as misspelled names, outdated addresses, or mistakes in identity; 22 percent listed a mortgage twice or included a mortgage and balance that had been refinanced and eliminated. And 30 percent showed open balances on accounts that had been closed.
Here’s an example of how errors affect you. William was the third person in his family with the same name as his father and grandfather. He was receiving notice after notice from credit card companies, advising that his interest rate was being raised. Three accounts changed in a short period of time, from 2.9 percent to 27.9 percent, from 5.9 percent to 32.9 percent, and from 7.9 percent to 34.9 percent. That’s not all. J.P. Morgan-Chase raised his minimum payment from 2 percent to 5 percent. Why was this happening? When William was attending school at Oklahoma University for his bachelor’s degree, he had received a lot of credit card offers and he signed up for all of them. He had been disciplined and never used his accounts. The companies kept raising his limit over five years, over and over. In fact, Citibank had been so generous that they had raised his original line from $1,000 to $30,000.
Lacking financial assistance from his parents due to the economic downturn, and due to the loss of his father’s business, William felt his only choice was to charge his tuition and living expenses on his credit cards once he moved on to law school at Georgetown. This was the first time he had ever gone into debt on his credit card accounts. He also knew he would be able to pay down and off his credit cards once he got out of school and into the practice of law. What William didn’t expect was that his interest rates would spiral out of control. Not only did his rates climb drastically, his credit card companies also reduced his lines of credit.
He was so close to his final goal of being a lawyer and was set to graduate in six months, but his financial life was in jeopardy. Why was everything out of control? William finally picked up the phone and called one of the companies and he couldn’t believe what he heard. They said he had made late payments and the pending bankruptcy was hurting him. He asked, “What late payments and what bankruptcy?” He pulled his credit report only to discover that his father—who had the same name—had filed bankruptcy, and his information had ended up on William’s credit report. His father’s financial struggles now transferred to William, and the damage was already done.
The error on William’s credit report was big. Errors can be very minor with the same outcome. Brett and Heather walked into my office one day to apply for a mortgage loan. They were well dressed, well educated, and articulate. They had good jobs, substantial income, and were able to offer a large down payment. At first glance, they were the perfect applicants. Checking their credit reports seemed like a formality, but it turned out to be a disaster. They were devastated to learn that their loan would be denied due to their current scores. Although they had been responsible with their credit, they, like many other Americans, had three medical collections totaling a mere $250 that had taken a huge toll on their credit scores. They had proof that the negative items were to be removed from their credit report by agreement but in spite of the agreement, the action hadn’t been taken as promised, and Brett had not followed up on it. The biggest problem was that the seller of the house wanted to close in 10 days and even had back-up offers. This didn’t give Brett and Heather time to get the problem fixed, so they ended up losing out on their dream home altogether.
This story is not unique. Whether it’s medical collections, cosigned debt, or some unforeseen situation (job loss, divorce, bankruptcy, or any of life’s hurdles), this can happen to anyone and often does.
The Meaning of Your Score
You might not realize this, but you don’t have a single score. Everyone has three scores within FICO (the best-known system, developed in 1958 by the Fair Isaac Corporation). These are the scores calculated by the three credit-reporting bureaus, and they are going to be different because they do not all receive identical information about your credit or inquiries about you. For example, let’s say your Experian score is 650, TransUnion is 723, and Equifax is 799. A lender will not average these. They will throw out the top and bottom scores and use the middle one.
Always think of your credit score as your financial DNA. As far as lenders are concerned, that threedigit number is all they need to know about you.This difference in scoring is important not only when it comes to getting a loan approved at a good rate; it can also affect your insurance rates and your ability to get a job. Many employers obtain copies of applicants’ credit reports as part of the interview process. Because credit scores are indicators of financial responsibility, the selection of one person over another for a job could come down to the difference of a few points on a credit report. Under the Fair Credit Reporting Act, you are not required to grant permission to a prospective employer to pull your credit report. Refusing, however, could be viewed as “taking the Fifth,” and while employers will not admit it, your refusal may affect their final decision. So before applying for jobs, it makes sense to get copies of all three reports and make sure that there are no errors on any of them.
Why is this necessary? Many assumptions are in force regarding credit scoring and how those scores are calculated. These wrong assumptions, or a series of myths, include:
Myth #1: Lenders must report accurate information. A broad assumption among consumers is that lenders must report information correctly. If you believe this, think again. Of course lenders are expected to provide correct information. But just as a fast-food employee might forget to include your fries, mistakes are common. Ultimately it is your responsibility to make sure your credit information is accurate, and that any mistakes are removed.
Myth #2: Paying off credit cards every month will give me a higher credit score. It’s amazing that if you use your debit card at the store the money disappears from your checking account right away. But if you pay off your credit card in full every month your score will not be affected for up to 30 days. For example, let’s say you travel for work 20 days out of the month and you charge all of your business trips on your credit card. If you have a line of credit for $50,000 and you use $45,000, you are at 90 percent capacity. Then your company reimburses you the entire $45,000, and you pay off the credit card. Your credit score should go up immediately, right? Wrong. The credit card company only reports to the credit bureaus once per month. For example, let’s say on September 15 your Citibank card balance is $45,000 and on September 20 you pay off the card. If Citibank reports for the month on September 15, then your credit score on September 15 is based on a $45,000 balance. This keeps your credit score low for the next 30 days, until Citibank reports again, on October 15.
Myth #3: Paying off a credit card with a high balance will have larger effect on my credit score. Under the FICO scoring system, a credit card with a $20,000 balance on a $25,000 limit is scored exactly the same as a $200 balance on a card with a $250 limit. Both of them are at 80 percent capacity. So paying off the higher balance will have the exact same impact as paying off the $200 balance. Of course, the $20,000 card will cost you more interest; but if your goal is to improve your credit score, pay off the cards with smaller balances first.
Myth #4: I have a high income, so I should have a high credit score. Credit scoring does not take into account how much money you make. As a matter of fact, that information is not provided to the credit bureaus at all.
Myth #5: There is an effective means to predict who will become delinquent or default on a loan. The truth is, FICO tracking has become less efficient in recently years. One study concluded that in 2001 there was a 31-point spread between defaulted borrowers and those who pay on time. By 2006, the spread had fallen to only 10 points.6
In practice, the credit-scoring industry is a game played by lenders, borrowers, and the agencies themselves. This does not mean the system lacks value, however, there are steps you as a consumer can take to maximize your credit score. You have to know how the score is calculated and play by the rules of the game.
Credit scoring is a game that lenders and agencies play. If you are going to win, you better know how the game is played.The Credit Scoring Game
The methods used to calculate your creditworthiness are complex, mysterious, and may even seem illogical to most people. The confusion comes from the fact that several different and conflicting methods are used, and seemingly innocent decisions can have a big negative impact on your credit score.
Your score—the bottom line used to decide whether to grant credit and if so at what rate—is affected by many different factors, most of which are within your control. If you want to raise a low credit score, you can take steps today to begin the process. Hiring a company to magically improve your credit can be expensive and is not necessary. As a matter of fact, it can do more harm than good.
Credit score confusion arises from the fact that there are many methods used to define “good” or “bad” credit. A perfect score is 850 and the lowest possible score is 300 under FICO. The purpose of credit scoring is to distinguish the degree of likelihood that any one person will repay debt in a timely manner or if he or she is likely to default. It measures a lender’s risk.
The analysis of credit is based on credit data reported by three credit agencies: TransUnion, Equifax, and Experian. Before a lender will grant credit, a credit report is requested from one or more of these three, and that report is the primary basis for a lender’s decision. These decisions include whether or not to approve a loan application, the interest rate assessed, and levels of collateral required to secure the loan (percentage of down payment required for a mortgage loan, for example). The very first problem you face when lenders look at your credit score is that the three agencies will not necessarily have identical information. If you dispute an erroneous item with one agency and have it removed, that does not mean it is also removed from the two other agencies. They operate independently.
Scoring Methods
The methods used to develop your credit score are not isolated; your credit history is compared to other consumers as part of the rating. For example, if you have two late payments beyond 30 days on your record, your rating is determined based on statistical risks of other people with the same history. So if having two late payments equals a strong chance of default, the situation lowers your score.
Under the Federal Reserve Board’s Regulation B (which put the Equal Credit Opportunity Act into effect), scoring cannot be made based on race, religion, sex, or marital status. The rules also require that rating systems have to be statistically sound and, in the event the credit is denied, a lender has to disclose the specific reason. Having a score that is too low is not adequate; lenders have to explain exactly why credit was denied. For example, lenders have to peg excessive delinquencies, too many outstanding balances, or too many high-balance accounts outstanding as their reason for denying credit or curtailing terms of an existing credit account.
Since there are several systems in wide use, your score is likely to be unclear, especially if the three agencies produce different scoring numbers. The FICO scoring is widely used, so non-FICO methods are likely to mimic the FICO scores. Because they are not the same, these non-FICO scoring methods often are called FAKO. Some lenders rely on scoring systems sold by the rating agencies that cost less than FICO and mimic FICO scoring, often creating wide disparity among ratings.
Under FICO, your score is going to be based on five criteria. Each makes up a specific percentage of your overall score. This breakdown is shown below.
These criteria are:
Payment history: This accounts for 35 percent of your score. All history of payment, including late payments, is taken into account on mortgages, credit card, auto loans, and revolving accounts. Since this constitutes the highest percentage of your score, avoiding any late payments does more than anything else to keep your credit score high.
Credit capacity: This is 30 percent of your FICO score. It consists of the ratio between revolving credit debt and total credit limits. When you pay off a debt you lower your utilization, improving your score. However, if you close a revolving credit account, it actually reduces your overall score by lowering the basis for calculating the ratio. A problem with utilization: If you are carrying debt equal to 90 percent of a $1,000 line of credit, that is a 90 percent utilization ratio, even though the credit limit is low. It is counted the same way as carrying $9,000 on a $10,000 credit limit. The second part of capacity is a comparison between the number of cards with balances, versus the total cards you have. For example, if you have 10 credit card accounts and only three have balances, your capacity is 30 percent. If you close five of those accounts not being used, you end up with three out of five cards with balances. That is 60 percent capacity. This hurts your credit score. The goal of capacity is to always be under 50 percent.
Length of credit histor y: 15 percent of your total score is tied to how long you’ve been using credit. So the longer you have had credit, especially if you have been making timely payments, the higher your credit history score is likely to be. In today’s lending environment, lenders are looking for you to have at least three established accounts with a minimum of a 12-month history.
Type of credit: 10 percent of your score is made up of the types of credit used: installment payments, revolving credit accounts, credit cards, or consumer finance, for example. Consumer finance is considered higher risk than the other types, so avoiding high-risk forms of credit improves your score. This is granted by companies specializing in underwriting financing for any organization that does not directly offer credit cards. For example, Lens Crafters lets you buy glasses on credit, but the Lens Crafters bill comes from GE Credit.
Recent credit inquiries: The final 10 percent is made up of the number of credit inquiries appearing on your credit report. Recent searches and the amount of credit recently granted go into this number. When multiple credit inquiries are made in a short period of time, it can hurt your score. So if you apply for new credit cards or allow an auto dealer to pull your report, it can have a negative impact. Activity like this is considered risky because a rapid accumulation of new debt could take place soon after inquiries take place. Every potential lender knows this, and as a result, your score falls when a lot of inquiries are made in recent weeks or months.
Knowing the elements that go into your credit score will allow you to control it before it controls you.Your Credit Report
Your credit score is the ratings number assigned to you as a result of your credit history and current credit activity. Your credit report shows the itemized details used to arrive at the score. Each of the three reporting agencies develops your report based on information they receive, and they do not always have identical outcomes. Basically, though, your credit report includes:
• A summary of negative issues (bankruptcy, liens or judgments, delinquent accounts, and late payments)
• A listing of credit card accounts including issuer, account numbers, credit limit, current balance, and payment history—as well as a distinction between on-time payments and those falling into the negative category
• Mortgages and other debts including original loan amount, current balance, monthly payment, and number of late payments if any
• Credit inquiries
• Credit capacity
All of this information goes into the calculation of your credit score. Remember, there are three agencies, so you are going to have three different credit scores. The three might also have errors in items as straightforward as your personal information: current and past addresses, aliases, and marital status, for example.
It’s your responsibility to correct errors on your credit report. Don’t assume someone else will fix them for you.Situations I Have Seen First-Hand
Now that you have the nuts and bolts, a broad overview of the credit system and how it works, you should ask, “Why is it important for me to check my credit reports and make sure they are accurate?” Another important question is: “How can I improve my credit score?” Remember, two items—payment history and credit capacity—make up 65 percent of your overall score. So any steps you can take now will gradually improve your credit score.
The credit score has a significant impact on your life. To demonstrate, following are some situations I have seen firsthand.
The Convenient Subscription Deal
Mark used an automatic bill pay feature on a credit card for the newspaper subscription on a credit card he almost never used. He was an honest guy who paid his bills on time, worked hard, and followed the rules. But he neglected to open the monthly statement because it usually showed a zero balance; he forgot that he had placed his subscription on that card. The subscription charge was on there, though, and it went past due and into collection. His credit score dropped to 560 as a result of his not opening the statement and making a timely payment. This was a costly mistake. It took years to recover from a small oversight, but this was entirely his responsibility.
The Inquiry Effect
Bob and Sandra were prequalified to build their dream home. As the house was built, they shopped for furniture, appliances, and other items to fill their home. They were excited that their American dream was about to be realized after years of careful financial management. At last their hard work was going to pay off. But trouble began when we reviewed their updated credit reports. I had advised Bob during our initial meeting how important it was not to purchase any items during the loan process. Sandra had not been present at the meeting because she had to work, and Bob never shared the information with her. He didn’t want to disappoint her by telling her she couldn’t shop. Their scores were unexpectedly low as a result of the inquiries they had authorized. Their American dream turned into a nightmare when I had to tell them they could not qualify for the loan. They had to wait until the inquiries fell off of the report several months later. They found out too late how the system works. Meanwhile, property values went up, and they were forced to settle for a smaller house for the same money—all because of excessive inquiries on their credit reports. This is why people need to understand and pay attention to the credit system and how it works.
Never make large purchases or open new accounts when a lender is evaluating your loan application.How is your credit? Are you at risk for one of these unexpected surprises based on errors in your credit report or inadvertent negative items resulting from innocent behavior? The only way to know is to review your credit report at least once per year. Amazingly, 144 million worked-age adult Americans—that’s 64 percent—have not reviewed their credit report during the past year.7
It is unlikely that many people can avoid being a part of this system. In 2000, there were 159 million credit cardholders in the United States, 173 million by 2006, and an estimated 181 million by 2010. At the close of 2009, there were 576.4 million credit cards in circulation, averaging 3.5 cards per cardholder.8
Having a lot of credit cards isn’t a problem as long as payments are made on time, right? Well, more than one in four—26 percent or 58 million people—say they do not pay their credit card bills on time. This not only reduces their credit scores, but creates an incredible profit center for card issuers in the form of late fees.9
Strategies for Taking Control
To take control of your credit and avoid becoming one of those statistics—and to increase your credit score—follow these steps:
1. Pull your credit report today. Make sure it is based on the FICO scoring to make comparisons valid, and pull reports at least once per year, and more frequently if you have gone through major credit-changing events such as divorce, bankruptcy, or foreclosure.
2. Pay off revolving debt before applying for financing. If you pay off your existing revolving debt, especially on accounts with finance companies, you will raise your score. Pay the accounts down to a zero balance 45 to 60 days before applying for new financing to maximize your score. And remember, don’t use those accounts in the meantime.
3. Shop for financing before signing a contract. Always get preapproved before ever signing on the bottom line. Many lenders make a lot of money charging high interest rates to customers who have fallen in love with a new car, home, or product and will blindly go along with the financing arranged by the inhouse finance company. By getting preapproval you can focus on negotiating a better price rather than on financing your purchase. Don’t shop based on “payment” but on the true overall cost. Remember, many companies send out credit applications to multiple lenders and take the fastest approval, not the best terms. It’s fast for them and bad for you.
4. Pay for a credit monitoring system—this is valuable credit insurance. A credit monitoring program costs about $100 per year, but protects you from potential credit issues. You are immediately notified when inquiries are made or when delinquencies are reported. This allows you to prevent errors and other problems in advance (including identity theft), rather than trying to fix them after they have appeared on your report.
5. Avoid negative scoring due to excessive inquiries. There are two types of inquiries: hard pulls and soft pulls. A soft pull is any inquiry that does not affect your score, such as inquiries by your insurance company and requests you make for your own credit report. A hard pull can affect your credit adversely and remains on the credit report for as long as one year. This is generated whenever you give someone else permission to get a copy of your credit report. This could be a perspective landlord or a potential lender. Applying for a credit card is a common form of hard pull. Every hard pull lowers your score. The inquiry also shows up on your report and will be visible to anyone reviewing it. Multiple inquiries can create great damage. So if you are building a new home and you open accounts (or put in applications) for three credit cards, and three other stores (home improvement, flooring, window treatments), that’s a total of up to six hard pulls and can have a negative effect on your credit score.
A small investment in credit monitoring is a must and can prevent huge problems later.There are many secrets and strategies to managing your credit score. Knowledge and diligence are key. You need to know how your innocent actions can result in damaging your score, and having negative items may show up on your report as a result. You can manage your score by keeping inquiries down and by managing capacity ratios before you apply for credit anywhere. This will result in better approvals and lower interest rates. Basically, joining a minority of people who are even aware of how their credit score is calculated makes you a better-informed consumer and a smarter credit user.
The problems you can face as a result of your credit score can appear in just about any situation, even those where you don’t directly use credit (such as in job applications). For most Americans, the event of greatest importance and consequence is in financing a home. This is likely the largest purchase you will ever make, and yet many people do little or no research when selecting a Realtor, understanding the cost of homes in the area, or financing options. Some spend more time researching refrigerator brands than they do when they buy a home. The next chapter explores this topic and provides you with valuable guidelines for being a smart homebuyer.
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