Understanding Credit Reports and Scores

Lenders look at your credit report every time you apply for credit, but many people don't know what their credit score is or how the score is calculated.

What's A Credit Report?
A credit report is a document that lenders use to assess a person's credit risk. It shows your payment history for the last seven years, the amount of money owed, the types of credit in use, the proportion of balances to credit limits, delinquencies and public records including bankruptcies and foreclosures.

What Determines Your Credit Score?
Your credit score is a numeric representation of your financial responsibility, based on your credit history. Your credit score is determined by several factors:

1. Payment History: This is the biggest factor in determining your credit score. It shows whether you've paid your accounts on time and whether you've been delinquent in making any payments. It also shows if you've ever filed for bankruptcy or been foreclosed.
2. Amounts Owed: This is another big factor in determining your credit score. Having credit accounts and owing money doesn't mean you're a high-risk borrower. But owing a lot of money on several accounts might suggest you're overextended, and thus a higher risk.
3. Length of Credit History: Generally, having a longer credit history is better than having a short credit history. Lenders need to see that you can manage your credit accounts responsibly over time.
4. New Credit: Opening several new credit accounts in a short amount of time can be viewed as a higher credit risk.
5. Types of Credit in Use: This includes credit cards, retail accounts, installment loans, finance company accounts and mortgage loans.

A Few Misconceptions About Credit Scores:
Some people think that they can't get a mortgage because their credit score is too low. Actually, this isn't necessarily so. Some mortgage lenders offer loans designed for people with past credit problems.

It is also a misconception that paying off a delinquency can raise your score. Since delinquencies stay on your report for seven years, this isn't entirely true. Delinquencies are viewed as a weak commitment to paying off your debts. Though, provided your recent payment history is better, those past delinquencies will bear less weight over time. And you should always pay your delinquencies.

The Consumer Federation of America and Fair Isaac Corporation conducted a study and found that nearly 45% of respondents think that making more money will improve their credit score when, in fact, your credit score is not determined by your income, but by the factors listed above.

Understanding what a credit report is and how your score is determined is a good first step towards improving your credit.