The Credit Rating System

Today's media has seen a steady increase in the advertisements for various types of loans. These ads are often targeted toward individuals with "good credit" or "bad credit". What exactly do these terms mean and how are these categories determined?

When an individual applies for a loan they are required to give the lender permission to check into their financial background and history. The lender sends an inquiry to a company that houses vast amounts of personal financial data. These companies are called Credit Reporting Agencies. The lenders will use at least one of three agencies: Equifax, Experian and TransUnion.

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These agencies are able to take the personal information supplied by the lender and pull up the pertinent information.

The Credit Bureaus then gives each person a score based on the 5 main aspects of a person. s financial situation.

1. The total amount of money that the individual owes.
2. Has the person been on time with payments?
3. Does the individual have an established line of credit? (For how long?)
4. How much credit has the person applied for recently? (Too many applications could raise a flag)
5. The sum number and types of credit accounts the individual has? (Too much credit could be considered a negative factor)

The Bureaus process this information and produce a credit score. Often times in the US this is referred to as the "FICA score" because most of the agencies use software developed by Fair Isaac and Company. The resulting number ranges from 300 to 850. People who score well fall in the category of "good credit". They generally have an established line(s) of credit, are not overextended, and have made their payments on time. However, there are no set rules in regards to where the line is drawn between good, ok, and poor credit. Each lending institution has their own standards and requirements. They take the scores into consideration and also add in additional factors such as, occupation and income level. Once they have they have collected and reviewed all the information they determine whether the loan is approved, and what the interest rates will be. A general rule of thumb is that people with good credit will receive lower interest rates because they are considered lower risks.

It is important to note that a credit score is very fluid. It can change over time as your financial situation changes. By carefully managing one's finances over a period of time, a credit score can most definitely increase.

Mark Carney is a professional consultant with First American Debt Consolidation and Loans, a debt consolidation service specializing in financial education, credit counseling, and debt management services nationwide.