On Approved Financing

Part I: How Credit and Credit Scores Work and What You Can Do to Improve Your Credit Score

By Gatlin Groberg

Nobody carries cash anymore. We just don’t do it. Charging your purchases on credit cards instead of pulling out dollar bills for them is the social norm and has been for quite some time. However, have you ever asked yourself how that practice is affecting your credit?

To understand credit, you must first understand what it affects. For example: employers may look at an individual’s credit history to determine whether or not to offer them a job, a landlord may deny housing to an individual with negative remarks in their credit history, and bar examiners – that means you, law students – may determine eligibility to practice law based upon a person’s credit history.[1] One of the requirements for law students in applying for the bar is submitting an affidavit attesting to their character and fitness; most state bars include “financial responsibility” as a factor in determining character and fitness for bar passage.[2] Recently, the Ohio State Bar considered an applicant’s high credit card debt as a factor in denying his eligibility to practice law – the Ohio Supreme Court later affirmed the state bar’s decision.[3] There are countless stories of people being denied qualification for an apartment because of a past late payment, or denied a job because of a bankruptcy. Credit is not only an issue that affects your finances, but can cross over into every other area of a person’s life.

Understanding how credit works and using that information to maintain good credit and a high credit score can prevent the denial of housing, employment, and yes, even entrance into the legal profession. It also establishes trust and accountability to anyone viewing your credit history. This article is the first in a three part series about how credit works, the policies behind credit, and what changes to those policies are being contemplated for the future.

WHAT IS “CREDIT?”

When a person talks about their “credit,” they’re probably either talking about their credit history or their credit score.  It’s important to understand that a person’s credit history and their credit score are entirely different concepts that interact with one another, but in other ways have little to do with each other. Under most contexts, a credit history is a personal history of the money that has been lent to an individual. A credit history shows all the different credit related accounts a person has, how long they’ve had those accounts, and how they’ve either positively or negatively used the money that has been lent to them (i.e., made payments on time, high balances, etc.).

On the other hand, a credit score is something else entirely. A credit score is a numerical risk assessment of how likely an individual is to repay the money that has been lent to them. A credit score is generated by a private company and generally ranges from 300 to 800.[4] The higher the credit score, the less potential risk to the lender. The lender may be willing to give an individual with a higher credit score a lower interest rate or a higher credit balance. Conversely, the lower the credit score, the more risk there is to the lender. The lender may give an individual with a lower credit score a higher interest rate or cap the amount of money they’ll be willing to lend.

One of the trickiest things about credit scores is that there are many different companies generating their own credit score brand.[5] That’s right; there is not a sole credit score out there. This is important to understand because the difference in two separate credit scores may be confusing until you realize that they’re generated by separate companies. In the next segment of this series, I’ll give some examples of the companies that generate credit scores; which include the three major credit reporting agencies.

Now that we know what credit and credit scores are, let’s answer how a credit score is calculated.

HOW IS CREDIT CALCULATED?

To determine your credit score, most scoring models look at five key factors:[6]

  1.       Payment History

A consistent record of on-time payments can help and improve your credit score. This will show lenders that you pay your bills on time. Creditors and lenders love that! In return for consistent on-time payments, creditors and lenders are more willing to lend to you than if you had any late payments show up on your credit history. For example: If a lender looks at your credit history and sees that you’ve had many late payments with a lender or lenders, they may not be willing to take the risk of lending to you because they’re not confident that you’re going to pay them back on time. This will reflect with a lower credit score as well.

  1.       Outstanding Debt/Amounts Owed

This factor typically applies to credit cards more than anything else. High balances in relation to your credit limit can lower your credit score. Aim for balances under 30% of your credit limit. The big question creditors ask when they see high balances on credit cards is: “What happens if you’re suddenly not able to pay that credit card off?” High balances = risky behavior. Avoid it if you can.

  1.       Length of Credit History

An established credit history makes you a less risky borrower. So think twice before closing old accounts. The rationale behind this factor is that an established credit history will show lenders that others have trusted you in the past. The longer the credit history, the more trust a person has established. There is a valid argument that this factor pigeon holes consumers into never cancelling a credit card; this issue will be addressed in much more detail in the second part of this three part series.

  1.       New Credit Inquiries

When a lender or business checks your credit, it causes a “hard inquiry” and a slight ding to your credit score. The rationale behind this factor is that every time a lender looks at your credit history, that hard inquiry in and of itself becomes part of your credit history. If there are many inquiries from different lenders within a small amount of time, this may show lenders that you’re reckless in applying for credit and, in turn, a risk to lend to.  Therefore, apply for new credit in moderation.

Fortunately, there is a way to look at your score without causing a hard inquiry on your credit history. When a person checks their own credit score, this is considered a “soft inquiry.” Since the score is not inquired into by a third party for lending purposes, it will not even show up on your credit history. There are many different businesses a consumer can contact to see their credit score; one of them is the Fair Isaac Corporation (FICO). FICO generates the score model that most banks and lenders base credit approval off of.[7]

  1.       Types of Credit

A healthy credit history has a balanced mix of credit accounts and loans. This shows lenders you were able to handle a versatile amount of credit (i.e.; auto loans, credit cards, mortgages, boat loans, etc.). A versatile credit history may go a long way in getting the things that you want.

THE FICO CREDIT SCORE MODEL

Below is the FICO score model that shows how the different credit scoring factors affect your credit score. You can see payment history affects your score the most. That means on-time payments are the most important factor affecting your score.

How a FICO Score breaks down:

FICO chart[8]

Knowing the percentage each factor contributes to your overall credit score can greatly impact how you use your credit and which area of your credit you may want to concentrate on.

Part II: The Three Major Credit Reporting Agencies and Negative Items

In part two of this three part series, I’ll go into an analysis of the three major credit reporting agencies, statistics on how long negative items in your credit history can be reported, and the difficulty in getting mistakenly reported items off of your credit.

Keep reading the blog; we’ll see you again shortly!

 

[1] Lea Shepard, Toward A Stronger Financial History Antidiscrimination Norm, 53 B.C. L. Rev 1695, 1696 (2012).

[2] Comprehensive Guide to Bar Admission Requirements 2014 vii (Erica Moeser & Claire Huismann eds., 2014), available at https://www.ncbex.org/assets/media_files/Comp-Guide/CompGuide.pdf (Relevant conduct . . . [the] neglect of financial responsibilities).

[3] In re Griffin, 943 N.E.2d 1008 (Ohio 2011) (Applicant had $16,500 of credit card debt in addition to student loans).

[4] Fair Isaac Corporation http://www.myfico.com/CreditEducation/CreditScores.aspx (last visited March 17, 2014) (FICO credit scores range from 350-800).

[5] Elkins v. Ocwen Fed. Sav. Bank Experian Info. Solutions, Inc., 2007 U.S. Dist. LEXIS 84556, 58 (N.D. Ill. Nov. 13, 2007) (“The lending industry has many different types of credit scores on the market today. Many different vendors have created them, such as Fair Isaac, the three national repositories, credit grantors, and insurance companies.”)

[6] TransUnion, http://www.transunion.com/personal-credit/credit-reports/how-credit-scoring-works.page (last visited Feb. 26, 2014) (TransUnion is one of the largest credit reporting agencies in America and one of the primary sources banks and lenders use in assessing a person’s credit history).

[7] Fair Isaac Corporation, http://www.myfico.com/crediteducation/whatsinyourscore.aspx (last visited Feb. 26, 2014).

[8]Id.

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