n the late 1980's Equifax, TRW and TransUnion began working with Fair Isaac Co (San Rafael, CA) to develop generic scoring models to identify the comparative risk of delinquency amongst applicants based on characteristics within the credit report.

Each Credit Bureau offers a product which scores their credit report using the Fair Isaac (FICO) model. You may see these products referred to by their trademark names:

EQUIFAX provides BEACON


EXPERIAN/TRW provides EXPERIAN/TRW FAIR ISAAC SCORE


TRANS UNION CREDIT provides EMPERICA

Each Credit Bureau developed an independent model in partnership with Fair Isaac. The scores are weighted so that an Equifax score predicts the same level of risk as the same score value calculated on a TRW Credit Report. It is very possible that an individual borrower will have a different score with each bureau as the contents of that individual's credit file will differ between the three Credit Bureaus.

The Credit Bureaus each provided Fair Isaac with a very large sample of randomly selected credit files. They provided the current file as well as a copy of that file as it appeared 24 months before. The files were compared and separated into two groups: Those who were delinquent within 24 months and those who were not. The sets of files were analyzed and a number of characteristics were identified as "predicting" the delinquent behavior. It is these characteristics that are reviewed when a score is calculated.

The FICO score product(s) provide a score which identifies the risk of delinquency within 24 months as well as codes which identify the credit bureau file characteristics which contributed most heavily to the final score. These would be the characteristics which deviated most significantly from the characteristics of the "good" group.

The score is meaningless by itself and must be used in conjunction with a validated cut-off strategy which may be different for the various users of the score. An auto dealer may accept a lower score than a credit grantor who offers unsecured lines of credit. A credit grantor must balance the risk of eliminating good customers in addition to the benefit of eliminating risky customers when establishing an acceptable cut off score.

The score is dynamic and is calculated at the time a credit file is accessed from the credit bureau. There is no way to "manually" adjust a score in the event that a piece of data in a credit file is inaccurate or not current (i.e. balance, late payments, collections, etc.).

Inquiries are important factors in the score and each time a credit report is accessed a new inquiry is placed in the file. The next time that file is accessed the inquiry could potentially worsen the score. This is why it is not a good idea to review the report periodically in order to see if the score has improved.

The score is calculated by the Credit Bureaus (Equifax, TRW, Trans Union). While a credit reporting company is able to make changes to a Residential Mortgage Credit Report, the changes do not impact a FICO score. The Borrower should correspond directly with the credit bureaus to effect any permanent changes to his or her file. This has to occur before a new inquiry will show a revised FICO score.

To evaluate risk in their decision to lend to a particular borrower. Taken as a whole, these three categories give lenders a fairly accurate view of your financial picture. Knowing how lenders measure them and what they're looking for can help you get your financial picture clearly in focus (to extend the metaphor), and present yourself as favorably as possible in order to qualify for the best rates and terms your individual situation will allow. Since an understanding of Credit, Capacity, and Collateral is highly important for the prospective borrower (and all consumers, actually), we'll discuss each one in turn, below.

redit, for our purposes here, means the overall credit picture; the credit accounts that have been extended to the prospective borrower, and the history of how those accounts have been paid.

The credit report is the means by which potential creditors (those who extend you credit, whether car dealers, retail stores, banks, etc.) look at your history of handling credit. The credit report contains a history of how the payments on accounts were made for the most recent two-year period (along with other information such as any charged-off accounts, liens, judgments, or bankruptices). The information that makes up a credit report is collected and stored by credit reporting agencies.

Each time you are extended credit or make a payment on an account, that information is stored in a computerized repository by one (or more) of the three credit reporting agencies or bureaus; Trans Union, Experian (formerly, TRW), and Equifax. Since a particular agency may have information concerning an account that another may not, many lenders obtain a report that combines the information from all three agencies. This combined information is called a merged report or merged bureau. The idea here is that while one of the agencies may not have complete information concerning the borrower, it is highly unlikely that a combination of all three would miss something. Still, errors can and do occur, which is one of the reasons why it is important to see a copy of your credit report before applying for a loan.

To avoid any unpleasant surprises, you should know what your prospective creditor is going to see on your credit report, so any errors or derogatory information can be corrected and/or explained before the loan application. In the case of derogatory information on your credit report that is correct, you may not be able to have it removed from the report until you take the necessary action to remedy the original reason for which it was added (certain items such as liens and judgments, will stay on your credit report until they have been satisfied). Any derogatory information on your credit report that can't be removed or explained to the lender's satisfaction can have a negative impact on obtaining financing, or obtaining the most favorable terms.

Only two things can actually repair or "fix" one's credit; 1) making payments on time as agreed, and 2) the passage of time, usually two years. Each month, as payments are made to the various accounts, the record of those payments are added to the front end of the two-year payment history. At the same time, the record of those payments now over 24 months old drop off the back end of the history. Having your credit report show that all accounts have been paid as agreed for the past two years goes a long way toward showing a lender that you are a good credit risk. Some types of loan applications (such as those using Fannie Mae underwriting guidelines) may require you to explain any derogatory information no matter how long has passed since it was reported. However, the most recent two-year period is the most important.

Here is an example showing a two-year account history for a credit card. Reading the history of payments from left to right, the slash (/) is the division between the most recent year (months 1 through 12), on the left side, and the second year (months 13 through 24) on the right side. The most recently reported month would be the first asterisk (or number, if applicable). By counting back, you can determine that payments were 30 days late in January of 1996 and August of 1995, and another payment was 60 days late in April of 1995.

Because payments have been made on time since February of 1996, by the time the April 1997 period is reported, the 60-day late payment of April 1995 has dropped off the two-year reporting period. It will take nine more months from the April 1997 reporting period (January 1998) until this account once again shows a perfect two-year payment history. This should illustrate why it is so important to maintain your good credit standing once it has been established.

The best loan risks are those people who have:

neither too few nor too many open accounts (lenders like to see a minimum of three trade lines)

a variety in the type of accounts (for example, a car loan, home mortgage, store account, and a couple of credit cards, as opposed to a dozen credit card accounts and nothing else)

always paid on time as agreed

Having some derogatory items on your credit report does not mean that you will be unable to obtain financing (it is estimated that over 80% of all credit reports contain some derogatory items). It does mean that you will have to explain the derogatory items to the lender's satisfaction, and in some cases require you to accept terms more favorable to the lender (and less favorable to you), and/or use Subprime financing (also called B-C-D or Non-conforming financing) to obtain your loan.

Lenders are looking for three things when they ask you to explain any derogatory items listed in your credit report:

Why the derogatory item shows up on your credit report (what happened, or what were the circumstances that caused the derogatory item)

What steps were taken to resolve the problem (what you did to "fix" the problem)

Why it will never happen again (an explanation of what has changed, or the steps you have taken, to ensure that such an occurrance is not repeated)

Explanations need to make sense to a lender. Saying that you got behind in your payments because you just didn't get around to making them on time, or because you lost the money at the casino isn't going to garner the lender's sympathy and understanding (or their money). A more reasonable explanation would be some sort of unforseen catastrophic event (such as the severe illness of a family member) that strained your resources and made you choose between taking care of the problem, or paying on time. Your explanation of why and how it will never happen again needs to show that either you have taken positive steps to remedy the situation that led to the late payments, or that circumstances have sufficiently changed so that it's highly unlikely that such an occurrence will be repeated.

Getting control of your credit is the first (and perhaps most important) step in The Three C's of Financing. The next, is Capacity.

apacity is simply defined as one's ability to make the payments on an obligation (the capacity to pay) according to lender-defined parameters. Depending upon the lender and the underwriting guidelines for the type of loan applied for, there are various methods that lenders use to determine the borrowers capacity to make the loan payments on time and as agreed.

Consider as a rough estimate that the capacity for a borrower's monthly housing payment is approximately 28% of gross monthly income* (45% if using Subprime financing). That brings us to the third and last step in The Three C's of Financing, which is Collateral.

*Different loan programs, such as Conventional, FHA, and VA use slightly differing ratios, though the numbers stated here should suffice for the purpose of the example.

ollateral is defined as something pledged as security for a debt. In the case of most home mortgages, it is the home itself. Traditional financial institutions will normally require the home being financed to be the collateral or security for the debt. The value of the home (collateral) is determined by having it appraised. Sometimes, lenders may even ask for additional security, such as having more than one property acting as collateral. Depending upon the type of lender involved, though, it may not have to be the property being financed, and it could be anything of value.

The lender normally determines the guidelines for what it considers to be acceptable value as security, in that lenders operate by the Golden Rule: "Them That Has The Gold Makes The Rules." However, it does not necessarily have to be all one way (the lender's). For example, a real estate transaction between private parties could use as collateral whatever could be negotiated as agreeable between the buyer and seller. That could be the real estate itself, other real estate, raw land, cars, boats, rare coins, even jewelry; anything of value that the buyer and seller could agree upon.