How Credit, Credit Ratings, and Your Credit History Work

That's not how it works. That's not how any of this works.

There is so much scandalous bullshit thrown out about personal finance that it's enough to make a goat lose its lunch. But most personal finance topics (once you weed out all the bullshit and bad advice) are pretty simple and short. Credit is a little different, in that a number of powerful players have taken action to make this as confusing and consumer-unfriendly as possible.

People have really spotty understandings of what a credit report is, what a credit rating is, and how all this affects you. But understanding that stuff is key to being able to fix your credit, and to monitoring it and keeping your credit score high.

What's the point of all this?

All this credit reporting and analyzing machinery is about letting companies that want to loan money determine how risky a particular loan would be. Why do they care? To explain, I'm going to describe two people (Who are totally made-up and not at all based on real people in my immediate family not at all why would you think that?) and ask you to imagine loaning each of them $1000 of your money.

Person 1 (I'll call her Sarah) has worked the same job as a registered nurse for 10 years, and is a stable, church-going single mom. She's always been very good at keeping her word. If she says she'll do something, she does it.

Person 2 (I'll call him Joe) has a hard time keeping a job for more than a year or two, and he's often a long time between jobs. He sometimes lets mail pile up for months without dealing with it, especially when he's been drinking, which he usually is when he's not working. We all love Joe, but we keep wishing he'd grow up a little and get his shit together. (He's 39, so the odds aren't good.)

I want you to imagine your reaction if each of those people came up to you asking for a loan of $1000 for a month. For Sarah, you'd be happy to loan her the money, and you'd probably do it either for free or for a very low rate. You're not worried about Sarah paying you back.

Joe is a different story. There's a real chance he won't pay you back on time, or at all. If you'd charge Sarah 2% ($20 on a $1000 loan) you'd charge Joe much more -- maybe 30% ($300 on a $1000 loan) if you were willing to loan him money at all. (I'm pretty sure charging people interest for loans is illegal as hell unless you're a bank. So don't actually do that.)

Whenever you apply for a credit card or a car loan or a cell phone plan or a home loan, the lender wants to know if you're a Sarah or a Joe. That's what all this complicated nonsense is supposed to be about.

So who are the players and what do they do?

First are the lenders, who play two roles in this farce:

  1. When they're trying to decide whether or not to give you a loan (and what interest rate to charge you) they check your credit with a Credit Reporting Agency, like Equifax, Experian, and TransUnion. That's called "pulling" your credit. They get a copy of your credit report.
  2. After they've given you the loan, they report your status every month to one or more of Equifax, Experian, and TransUnion.

Next are the Credit Reporting Agencies, or, as I like to call them, Thieving Fucking Assholes. You'll often hear them referred to as CRAs, but I'm going to call them TFAs. (Imagine companies so exploitative that they make credit-card issuers look good -- that's the TFAs.) The main ones are Equifax, Experian, and TransUnion. They play two main roles here:

  1. Each lender reports your payment status to one or more of the TFA. (This is why your credit report will be different at each of the TFAs -- not all information is reported to all of them.) Also the TFA don't do any verification of anything that's submitted to them -- whatever inaccurate information a company submits to them (either through error or fraud) is vomited out into your credit report. The TFAs have made it your responsibility to monitor your credit and dispute erroneous information. Of course, they try to charge you money to monitor your credit, or freeze your credit, or get a copy of your credit report. The TFAs are only supposed to keep each piece of information about you for a specific time -- generally seven or 10 years, depending on what type of information it is.
  2. When a lender wants to make a credit decision, they pull your credit report from one of the TFAs, paying the TFA a fee. This is the purpose of the TFAs, collecting data on you that they can sell to businesses.

Finally we've got the rating agency, FICO. FICO is a private company, and uniquely among the players described here, don't appear to be acting like raging assholes. (Or maybe I just haven't dug deeply enough yet. There's untold depths of assholery in the financial industry.) FICO is probably the least popularly understood part of this deeply disturbed puzzle, but I think understanding how the pieces fit together is really important.

FICO provides a service to lenders, creating a single number that is supposed to encapsulate how much you're a Joe or a Susan. In our example earlier, we didn't need FICO because we were only looking at two people. But there's many millions of people looking for credit, and the lenders can't have a person read through someone's credit history and make a decision -- there needs to be an automated way of deciding how risky a loan to someone would be.

FICO's whole reason for being is that they figured out how to automate that evaluation. A lender pulls a credit report from one of the TFAs, then provides that credit report to FICO. FICO spits back a number (the person's credit rating). A FICO credit rating (there are other ratings agencies, but FICO is by far the largest) ranges from 300 to 850. Each lender sets their own standards, but generally, anything over 700 is considered good. Lower than 550 is considered bad.

The only thing FICO promises to the lenders is that a person with a higher score is less risky than a person with a lower score. So if the bank has 10,000 loans out to people with credit scores of 650, and 10,000 loans out to people with credit scores of 700, more of the people with a 650 credit score will run into problems making payments than the people with a 700 credit score. FICO doesn't say yes or no to a loan, they just say a number.

It's up to the prospective lender to decide whether or not that number is sufficient to make the loan. One bank may decide that anything over 700 is good, while a different bank may decide that 650 gets their good rate. It's totally up to the lender.

That's it! That's how the major pieces of the consumer credit industry fit together. In a future article I'll talk about how to dispute items on your credit report, and how to deal with collections agencies, and ultimately how to clean up your credit report and get a good credit rating.