How Do Credit Ratings Work?

Avoid a bad credit rating by understanding how you earn your credit score.

How Do Credit Ratings Work?
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Introduction
A good credit rating makes life more pleasant. You have access to credit when you need it and you'll pay lower interest rates on the money you borrow. Of course, it's a lot easier to build good credit if you know how credit ratings work. Your credit rating (also called a credit score) is a number that tells lenders how much risk you represent as a potential borrower. There are several credit rating systems, but far and away the most widely used is the FICO score (named for Fair, Isaac, & Co., who produces the scoring system). FICO is used by most lenders and by Experian, Equifax, and TransUnion (the major credit reporting agencies).
Credit Rating and Credit History
Credit reporting companies keep records consisting of information provided by lenders about how well (or poorly) you've kept to the terms of repayment agreements. Your credit history with each credit agency may also include information about your employment history, savings, and income. This information is coded and processed using the FICO system to come up with your credit score. It's a number from 300 to 850 that lenders use to determine if you are an acceptable risk and how much interest to charge you. Accuracy is important, so you should check the contents of your credit history periodically and make sure errors are corrected. You can get a copy of your credit history from each credit reporting agency free once a year (see link below).
Parts of a Credit Rating
No one knows exactly how a credit score is calculated. That is proprietary information and Fair, Isaac, & Co. doesn't make it public. However, the parts of a credit rating are public knowledge. How well you pay your bills on time counts for 35 percent of a FICO score. Another 30 percent is based on how much debt you have compared to your income. This includes available credit, so having several credit cards with high limits may lower a credit rating even if you run a low balance. The kind of debt counts, too (10 percent). Secured debt poses less risk, so it's better if most of your debt is in the form of a mortgage, car loans, or other borrowing for which there is collateral. Part of your credit history and hence your credit score is based on how often you apply for credit or close accounts (10 percent). Constantly doing this lowers a credit rating. Finally, how long you have used credit is a factor (15 percent).
Credit Problems
A credit rating is based on the data in your credit history, and if lenders don't report things like a late payment, they never affect your score. This makes it very much to a consumer's advantage to contact lenders if she is facing financial difficulties. Many lenders will make arrangements for otherwise good customers and won't report a late payment if the agreement is kept. There are some things to avoid if at all possible: the "credit killers." These are major problems like tax liens and defaults or a foreclosure on a mortgage. Bankruptcy is a black mark as well but it affects a credit rating differently than other problems. Following a bankruptcy, most of the existing information is expunged (removed) from a credit history and the bankruptcy is added. For many people, this has the net effect of leaving their credit rating much as it was just before the bankruptcy. However, credit rating is then calculated based on how other people with bankruptcies use credit rather than the general population. If a person takes care to use credit carefully and responsibly following a bankruptcy, it's possible to restore a fairly good credit rating in a couple of years.
Resources
reference
Authorized Free Credit Reports (FCC)
reference
The Scoring Game
reference
Credit Score Estimator