CREDIT INTRODUCTION

Your ability to qualify for credit depends on your credit report. A credit report is your financial record of your credit history. When someone applies for a loan, the lender will order a credit report to see how well the applicant has managed credit in the past. Credit reports are put together by the credit bureaus: Equifax, Experian, and TransUnion. Any lender you currently have credit from reports your payment history and your balance information to the three bureaus. Your report will include potentially negative items, accounts in good standing, credit history inquiries made by you and others, and your personal information such as places you have lived.

Individuals have the right to get a free copy of their credit report from each credit bureau once annually using the website www.annualcreditreport.com. When you apply for new credit, the lender will typically pull your credit report from one of these three bureaus. This is the reason you need to know that there are three bureaus so that you ensure that your information is accurate in all three places. You should annually check your reports and correct any mistakes you find in your credit report as it is unfortunately not uncommon for there to be reporting errors.

CREDIT SCORES

800-850: Excellent
740-799: Very Good
670-739: Good
580-669: Fair
300-579: Poor

Credit scores range from 300-850. The higher your score, the easier it will be for you to get credit and the lower your interest rate will be. The reason for the different treatment has to do with delinquency rates. Delinquency refers to your failure to pay debt. Below is an example of delinquency rates reported by the Fair Isaac Corporation (FICO) based on credit scores. 

CREDIT SCORES DELIQUENCY RATES

800 – 850: 1%
750 – 799: 2%
700 – 749: 5%
650 – 699: 15%
600 – 649: 31%
550 – 599: 51%
500 – 549: 71%
Under 499: 87%

Lenders do not know you personally; they will use your credit score to judge what they anticipate your delinquency rate is going to be. If your credit score is above 800, you are categorized with other people in this range who on average fail to pay their debts less than 1% of the time. Your credit score of 800 will lead lenders to consider you a safe borrower who repays their loans and consequently they will want to lend to you. If your credit score is below 499, you are categorized with other people in this range who on average fail to pay their debt 87% of the time. Your credit score below 499 will lead lenders to consider you a risky borrower and consequently they will not want to lend to you. You may be wondering why it is that lenders will assign people with low credit scores higher interest rates, which effectively would result in larger payments thus increasing their chances of being delinquent. I would like to present a few scenarios: (Please note these are not intended to be entirely accurate of what the lending process involves, but intended to have you consider this situation from the lender’s perspective.)

SCENARIO 1 – BORROWERS WITH HIGH CREDIT SCORE

Borrower 1 has an 800-credit score and is charged 2% interest every month on a loan. Let’s say their payment is $102 with $100 going to pay back the loan and $2 being the interest. At the end of the month, the borrower makes a payment of $102. The lender has now earned $2. The lender now takes the money paid by Borrower 1 ($100) and lends it to Borrower 2 with the same terms. At the end of the month, both borrowers make a payment of $102. The lender has now made an additional $4, which combined with the first month’s earnings leads to overall earnings of $6.

SCENARIO 2 – BORROWER WITH LOW CREDIT SCORE

Borrower 3 has a 400-credit score and is charged a higher interest of 3% every month on a loan. Let’s say their payment is $103 with $100 going to pay back the loan and $3 being the interest. At the end of the first month, they fail to make a payment. The lender has currently earned $0 and cannot give the original $100 to a different borrower. At the end of the second month, the borrower now makes both payments. The lender has now made overall earnings of $6.

CREDIT SCORE BREAKDOWN

There are five components that make up your credit score:

Component 1 – Payment History (35% of your Credit Score)
Component 2 – Amounts Owed (30% of your Credit Score)
Component 3 – Length of Credit History (15% of your Credit Score)
Component 4 – Types of Credit (10% of your Credit Score)
Component 5 – New Credit and Inquiries (10% of your Credit Score)

Credit Components