How Does a Credit Rating Work?

by Laura Agadoni, Demand Media Google
    Before you finance a car, the lender looks at your credit rating.

    Before you finance a car, the lender looks at your credit rating.

    One simple three-digit number, your credit rating, gives lenders an idea of how likely you are to pay them back. The higher your credit rating, the better you look to lenders. When you have a high credit rating, you can qualify for all sorts of things – a mortgage, credit cards, a car or even a job. But if your credit rating is bad, you will have a difficult time obtaining credit, and if you can get it, lenders will charge you a high interest rate for the privilege.

    Credit-Reporting Agencies

    You get a credit rating from a credit scoring system that the three major credit-reporting agencies, namely Experian, Equifax and TransUnion, use. FICO is the most common credit rating model, but there are others. No matter which model the credit-reporting agency uses, your rating comes from your past credit history. Your race, ethnicity, national origin, sex, religion and marital status are not factors in determining your rating; only relevant information is. Because your credit rating comes from statistics, it takes away possibly biased judgments from random loan officers.

    Keeping Records

    The big three credit-reporting agencies collect information on everyone who uses credit. The agencies give this information to lenders who subscribe to their service. If you take out a loan, use a credit card, lease a car, have bills, have an account go to collections or a bankruptcy, the credit-reporting agencies record this. The agencies also keep a record of who requests your credit information, which could be lenders, insurers, employers or someone who has a legal reason. You can also access your own credit report free once a year by going to AnnualCreditReport.com. It’s important that you look over your free report because you might find an error on it that is making your score appear lower than what it should be. You can see your report, but to view your actual score, you pay a small fee, usually around $15.

    Collecting Information

    Credit-reporting agencies gather information about once a month from more than 30,000 sources, mostly creditors, courts and collection agencies. After receiving new information, the agencies usually update their information within one to seven days, according to the Federal Reserve. When you are trying to repair a bad credit rating, it usually takes about six months to see improvement. All of the reporting and gathering of information is voluntary, but credit-reporting agencies are regulated by conditions in the Fair Credit Reporting Act.

    Understand Your Rating

    Understand the FICO scoring system, and you understand how all the rating systems work. The numbers differ, but FICO is the most widely used system. Your FICO score ranges from 300 to 850, with 850 being the best. Your FICO score comes from five categories. Payment history makes up 35 percent of your score, meaning whether you pay back your debts and if you do so on time. Basically, if you are consistently late with your payments and have an account go to collections, you may not be able to get credit until the negative information goes off your report, which takes seven years. Credit utilization is also a big part of your credit rating. If you max out all your credit cards, for example, you don’t look like a good credit risk to lenders. A good rule of thumb is to use only 20 to 30 percent of your available credit on any card you have. Your length of credit history is a factor because it shows your experience with credit. The types of credit you use also have a bearing on your credit rating. Lenders like to see that you have a mix of credit that you can handle, such as a credit card, department store card, car loan and mortgage. Acquiring new credit can also affect your rating. Don’t apply for a lot of credit before you intend to apply for a mortgage, for example.

    The Scores

    A good credit score is anything above 700, which is the range of 60 percent of the population. The median FICO score is 720. About 15 percent of people are below 600, which makes it more difficult to obtain a loan.

    About the Author

    Laura Agadoni has been writing professionally since 1983. Her feature stories on area businesses, human interest and health and fitness appear in her local newspaper. She has also written and edited for a grassroots outreach effort and has been published in "Clean Eating" magazine and in "Dimensions" magazine, a CUNA Mutual publication. Agadoni has a Bachelor of Arts in communications from California State University-Fullerton.

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