Understanding How Credit Reporting Works
Before we dive too much into how credit works we must first cover the big 3 credit reporting agencies (a.k.a., credit repositories).
The 3 Repositories
Credit reporting is first done by three main institutions. There are more of them out there, however, there are three that most vendors and lending institutions use.
Those companies are Experian, Equifax, and TransUnion.
These companies are only for U.S. citizens and only report on the credit for companies who sign up to report to them.
Most lenders and banking institutions will report to all three institutions but this is not always the case. It does cost the banks money to report to these institutions. And banks do want to report to them because it is a way to track any future borrower’s credit history.
Types of Loans
Also, there are only two kinds of loans in existence. Every loan can be broken down into one of these two main types of loans.
The loans are either revolving or installment.
Here is the difference. A revolving loan is a line of credit that can change on a monthly basis. It can go up, go down, or stay the same. Every month can be different. You will see all credit cards are these types of loans. You can charge $1000 and only pay $100 or the full amount. The next month you can do something similar and pay a different amount. Thus, the account can go up, down, or stay the same.
The other type of loan is the installment loan. This is a loan that can only go down each and every month. Mortgages are installment loans. In this type of loan, there is a one-time charge and you pay this loan down every single month. The amount of the loan does not go up (unless it is modified for some reason with both parties agreeing to it).
An installment loan can be set up to where the balance never goes down which I don’t normally recommend to people. This is called an Interest Only loan where you are only paying interest payments every month.
The 5 Reporting Criteria
When looking at someone’s credit history there are five main items that are reported from each institution. Knowing this a borrower can work this to their favor.
Here is how it mainly works…
Payment history (35% of your score)
Every bank wants to know that you are paying on time. Your past history payment is indicative of what your future payment will look like. This is the only way that they can attempt to predict the future.
If you are in a habit of paying on time then they expect you will pay on time in the future. Conversely, if you are in the habit of paying late then this means the bank will expect any future payments will also be paid late.
Percent of Credit Used (30% of your score)
The first thing we have to do is differentiate between revolving accounts and installment accounts.
An installment loan is one that you are paying down every month so these are really counted at all.
The revolving accounts are very important. If you are staying around the maximum limit then this will seriously affect your scores. As in the previous example, your past is an indication of your future.
It is an industry standard to keep your revolving accounts at 30% or less of the amount that is available. I have also heard that this is the total combined of all credit cards. I would also recommend that to keep any account also at 30% or less of usage.
One thing I mentioned in a previous blog is to make sure you are using your accounts. Don’t always pay them off to $0 every month. You do want to have activity on those accounts.
Length of Credit History (15% of your score)
A bank strongly feels how you work over the long haul is how you will perform into the future. This means the longer you have an account open the better suited you are.
The old saying “cut up those cards that you don’t use” is one of the worst things you can do. I will be the first one to say to never close an account unless you are being directed by a professional expert in credit restoration.
Once, many years ago, I canceled an account that had a very sizeable available limit because I got angry at some fees they charged. This one was over 10 years old. Months later when I was looking to buy my first home I seriously regretted it.
You see, my scores went down. The reason was I had canceled my oldest account.
And payment history is are you paying on time, consistently. When you miss payments, now or in the past, this will show as red flags.
New lines of credit (10% of your score)
In my article post Credit Improvement, I mentioned one way to improve your credit is to get new lines of credit.
I am not going to go too deep into that because I have an entire article on that one particular subject.
Suffice it to say that you are always wanting to get new tradelines going as a way to build your credit.
Credit mix (10% of your score)
This is a vague area as to what this means. I assume that having different kinds of credit in multiple areas shows that you are able to make all of those payments. One expert told me that you should always have 5 active tradelines at any one time.
Those can be two revolving accounts. One home installment loan; one car installment loan; and one other installment loan.
By paying all 5 on a timely basis shows that you are responsible and able to handle those month to month commitments.
What is My Credit Score
When you are looking to purchase a home a lender is going to be checking your credit. He or she will look at your real FICO score (not your Credit Karma score).
This lender will pull your credit in what is called a tri-merge report from FICO. They will mainly be looking at the middle score of the three.
The algorithm that each repository uses is similar but different. Also, not all lenders will report to each repository. Thus, the values will be different.
When qualifying for a loan the lender will use the score that is in the middle (called a mid-score). This is not the average of the three added together and divided by three. They are looking at the middle value. For example, if you had the following…
Equifax: 650 Experian: 690 TransUnion 705 — They would use the Experian value of 690 as your qualifying score for a loan.
It is best to always be aware of your credit and what is going on with it. One thing everyone should do is to get their credit pulled at least once per year. You can also find your real credit score by going to FICO itself. You should be able to pull your credit once per year for free. Or you can pull it a low cost and have monitoring services engaged to ensure your credit is safe.