Differentiating between credit reports and credit scores

Credit reports and credit scores are different from each other, and you should understand upfront what they are and aren’t. The following sections spell out their characteristics in greater detail.

Credit scores

Your credit score is a three-digit score based on information in your personal credit report. Because each of the big three credit bureaus (Equifax, Experian, and TransUnion) issues its own report, you actually have three different (although typically similar) credit scores.

FICO is the leading credit score in the industry and was developed by the FICO Company (formerly Fair, Isaac and Company). FICO scores range from a low of 300 to a high of 850. Most scores fall in the 600s and 700s, with the median around 720. As with college entrance examinations such as the SAT, higher scores are better. (In recent years, the major credit bureaus have developed their own credit-scoring systems, but most lenders still predominantly use FICO.) You generally qualify for the best lending rates if your credit score is in the mid-700s or higher.

The higher your credit score, the lower your predicted likelihood of defaulting on a loan (see Figure 4-1). Conversely, consumers with low credit scores have dramatically higher historic rates of falling behind on their loans. Thus, people with low credit scores are considered much riskier borrowers, and fewer lenders are willing to offer them a given loan; those who do so charge relatively high interest rates on those loans.

Understanding how credit scores are determined

You have many credit scores, not just one. The reason you have multiple scores is because each of the three major credit bureau reports has somewhat different information about you and generates a unique score. But most consumers find, not surprisingly, that their three FICO scores from the big-three credit bureaus are fairly similar.

Credit scores change over time as your credit reports change. If you have a low score, the potential for change is good news because you can improve your score, perhaps significantly, in the weeks, months, and years ahead. The bureaus weigh current behavior more heavily than past behavior, though increasing your score is harder to do than decreasing it.

To have a credit score, you need to use credit. The FICO scoring system requires you to have at least one account open for a minimum of six months on your credit report and one account that has been updated in the most recent six months (it can be the same account).

The factors that determine your credit score include the following:

• Your payment history: Your record of paying bills determines about 35 percent of your credit score.

  Your score decreases with a recent negative mark (a late payment, for example), with a high frequency of negative marks, and with the severity of the negative mark (for instance, a 60-day late payment is worse than a 30-day late payment).

• How much you owe: This factor, which accounts for 30 percent of your score, examines the total amount you owe, as well as the amount by type of loan. The more you owe relative to your credit limits, the more adverse the effect on your credit score (most Americans use less than 30 percent of their available credit). With revolving debt (credit cards, credit lines), the greater the gap between your balances and your credit limits, the better. Also, paying down installment loans (for example, mortgages, auto loans) relative to the amount you originally borrowed will boost your credit score.
• How long you’ve had credit: Generally speaking, the longer you’ve had credit, the better for your credit score. This factor, which comprises 15 percent of your score, considers the average age of your accounts as well as the age of your oldest account.
• Your last application for credit: Applying for and opening new accounts, especially multiple new accounts, can reduce your credit score. This factor accounts for 10 percent of your FICO score.
• The types of credit you use: The FICO score rewards you for having a “healthy mix” of different types of credit (such as a mortgage, credit cards, and so on), although FICO is vague about what the best mix is. This factor accounts for 10 percent of your credit score.

Valuing of a good credit score

Generally, the higher your credit score, the better the loan terms (especially the interest rate) you receive and the more likely your loan applications are approved.

Over the course of your adult life, having a high credit score can save you tens (and perhaps hundreds) of thousands of dollars. Additionally, you can earn more money by being able to borrow money to make investments, such as in real estate or a small business.

Lenders aren’t the only ones that use credit scores. The following individuals and organizations/companies also use credit scores:

• Landlords: A high credit score can lead to the approval of your apartment rental application.
• Insurance agents: A high credit score can help you qualify for lower rates on certain types of insurance such as auto insurance.
• Prospective employers: Significant problems on your credit report can cause some employers to turn you down for a job.

Jump-starting your credit score as a young adult

If you’re just starting out financially, you may not have a credit score yet, simply because you don’t have enough information on your credit report. Don’t despair. To obtain a credit score if you don’t yet have credit, the following actions help:

• Establish a checking and savings account (and even a debit card). Doing so demonstrates financial responsibility and stability.
• Get added to someone’s credit card as a joint or authorized user. The logical person to ask would be a parent. Make sure this person is very responsible and shares your goal of keeping a terrific credit report and score. And, be sure that you are fully responsible for making your payments in a timely fashion.
• Have someone with good credit cosign a loan with you. I would only advise doing this with a relative, and only if the two of you have a long discussion about what could go wrong and have an agreement in writing to minimize the potential for misunderstandings.

• Apply for a credit card after turning 21 years old and when you have a job, because approval is relatively easy.

  Just be sure to get a card with a low annual rate and no or a low annual fee. Consider a rewards card if the benefits you can earn are something you value and will use. And be careful not to rack up balances you can’t immediately pay off every month. Most important, don’t use credit cards if having them causes you to spend more than you otherwise would.

• If you can’t get a regular credit card, apply for a department store or gas charge card. Doing so is generally easier, but watch out for high interest rates and other fees if you can’t pay your bill in full each month. Alternatively, find out why you don’t qualify for a regular card; then work at addressing that shortcoming and reapply when your credit report and credit score have improved.
• Apply for a secured credit card. This type of card requires that you keep money on deposit in the bank that issues the card.

For what it’s worth, I am not a big fan of college students having credit cards. The reason is that most cards allow charging of substantial amounts and may lead to overspending. In the worst cases, some college students end up with large balances at high interest rates upon graduation in addition to all of their student loans. Having one credit card with a low credit limit that you can pay in full each month is worth considering because it can help build your credit rating and score.

Having a debit card is a better choice, in my opinion, for most college students because a debit card is attached to an account with a balance and thus prevents you from spending more than that amount.

Recommended websites for free credit scores

A few websites provide you with a free credit score without forcing you to sign up for something and/or provide your credit-card information. Here are some reliable sites:

• After verifying your identity on their website, Discover Financial Services offers your free Experian credit score with no strings attached or credit-card registration required. Visit their website at www.creditscorecard.com/registration. (Discover does have its own credit card, and it will pitch you that online.)
• The credit bureau Experian is behind the website FreeCreditScore.com, through which you can get your free credit score.
• Another free option to try is the FICO score simulator at www.myfico.com/free-credit-score-range-estimator, which provides an estimate of your FICO score based on your answers to a series of questions about your credit usage and credit history.

Websites to avoid

Many websites, including the major credit bureaus, purport to offer you your credit score for free, but more often than not, to obtain this supposedly free score, you end up having to sign up for an ongoing and decidedly not free credit monitoring service! You may not realize that you’re agreeing to some sort of ongoing credit monitoring service for, say, $50 to $100+ per year. I don’t recommend spending money on those services. Instead, for free, request your credit report from one of the three agencies every four months to make sure your credit information is accurate (I talk about reviewing your credit report in the upcoming section) and get your credit score from one of the websites that I recommend earlier in this section.

A number of web-based entities such as Credit Karma and WalletHub claim to provide you with your credit score for “free.” These sites don’t give you the FICO credit score that lenders most often use. Instead, the sites, which do a poor job of disclosure, give you one of the credit scores developed by the credit reporting bureaus, such as the TransUnion VantageScore. As with Discover, you will be pitched a credit-card offer after obtaining your credit score. That’s how they keep these sites “free” for consumers seeking their score without paying for it.

In addition to getting a somewhat useless credit score at such sites, remember that you’re sharing with them an enormous amount of confidential information about yourself. How some of these sites make money isn’t completely obvious, but I can guarantee you that it involves finding ways (legal, hopefully) of tapping into all that information you give them. That would certainly include things like pushing auto loans, credit cards, and home mortgage loans to people in the marketplace for real estate.

Identifying errors and getting them fixed

Carefully look through your credit reports for any potential inaccuracies. If you find any errors, you want to get them corrected quickly.

Follow these steps to ensure that you properly vet each report:

1. Review the identifying information to be sure that other folks’ information hasn’t gotten mixed up with yours.

   Look for the following errors:

   • Names that aren’t yours
   • Incorrect Social Security numbers
   • Incorrect date of birth
   • Addresses where you haven’t lived
2. Inspect the credit accounts for problems, such as
   • Accounts that don’t belong to you
   • Negative entries that don’t belong to you (such as late payments and charge-offs, which are amounts you supposedly borrowed that a lender no longer expects to get back from you)
   • Negative entries that are more than seven years old
   • Debts that your spouse incurred before marriage
   • Incorrect entries due to identity theft or a credit bureau snafu that mixed up someone else’s information with yours
3. Examine the collection actions and public records section of your report for the following errors:
   • Bankruptcies more than ten years old or ones that aren’t listed by a specific bankruptcy code chapter (such as a Chapter 7 bankruptcy)
   • Lawsuits, judgments, or paid tax liens more than seven years old
   • Paid liens or judgments that are listed as unpaid
   • Loans that went into collection that are listed under more than one collection agency
   • Any negative information that isn’t yours

If you identify any errors, you can submit corrections by using one of the online forms for disputing incorrect information that accompany your credit reports. All credit bureaus are mandated to investigate and correct errors within 30 days. Your persistence may be required.

Boosting your credit score

After you get your credit report cleaned up, here are some ways that everyone can improve their credit score:

• Pay your bills on time. The better your credit score, the more a late payment harms your score because such a change in behavior may indicate increasing financial difficulties.

  To avoid making late payments, consider putting your bills on an automatic payment system either through your bank’s online bill-pay service or the company’s auto-pay option (if they offer one). Major investment firms like Fidelity and Schwab also generally offer cash management accounts that provide similar banking services. If you’ve never used automatic payments and you’re skittish, try the system first with one company you trust the most. Another option is to put the charges on your credit card. Only do this, however, if you always pay your credit-card bill in full each month. Be cautious charging large bills on your credit card because using a big portion of your available credit can reduce your credit score. Also be sure that the companies you’re paying don’t charge an extra fee for using your credit card for payment.

• Pay down your debt. Paying down your debts over time is exactly the kind of responsible credit behavior that lenders want to see in the folks to whom they lend money. The lower the portion your balances are of your credit limits (try to keep them under 30 percent), the better your credit score will be. For this reason, you should avoid both consolidating debts and charging so much on a card in a month that you near the card’s credit limit.
• Avoid closing credit-card and other revolving accounts. Closing accounts makes your remaining balances look that much larger in comparison to your total available credit. Also, closing older accounts lowers the average age of your credit accounts, which reduces your credit score.
• Apply for credit sparingly. Applying for credit more frequently lowers your credit score.