Understanding Credit Scoring

How a lender decides whether or not to loan you money is very much dependent on your credit score. Many solo and small law firms are started using the owner's personal credit to obtain financing, so it is important to understand how credit scores work for both personal and business credit.

What is a Credit Score?

A credit score is calculated by using information from a person's loan application and credit report to determine the likelihood of a loan being repaid on time. Scores fall within a specified range, with a lower score meaning that the person is a higher lending risk, and a higher score meaning that the person is a lower risk.

Most credit scoring formulas look at particular factors, including: payment history, outstanding debt, credit account history, recent inquiries, and types of credit. Your loan application may also convey information as to whether you own a home, your occupation, and length of employment. The formula will compare the loan applicant to other consumers with similar profiles, and awards points for each factor that indicates that the applicant is more likely repay the loan. The total number of points is the credit score, which reflects how likely you are to make payments on a loan as they become due.

Checking Your Credit Report

Your credit report is a critical element used in any credit scoring formula, so you should obtain a copy of your credit report before you submit any loan applications. There are three major credit reporting agencies you can contact to obtain a copy of your report: Equifax, Experian, and Transunion. Once you receive it, review it carefully to make sure that the information is accurate.

Why is Credit Scoring Used?

Credit scoring is based on a statistical model so ideally it should treat all applicants objectively and achieve a reliable evaluation of an applicant's ability to repay a loan. A credit scoring system is prohibited from using race, sex, marital status, national origin, or religion as factors.

How Can You Improve Your Score?

Each creditor uses its own model to evaluate your credit so they are in the best position to advise what will improve your score. Generally speaking, however, ways to improve your credit score will involve the various factors that they consider:

  • Pay your bills on time.
  • Keep outstanding debt low.
  • Establish a credit history, and keep accounts open that reflect a longer history of timely payments.
  • Apply for new credit judiciously.
  • Don't have too many credit card accounts.

 

Business Credit

According to the Small Business Administration (SBA), many small business owners don't even know that that a business credit report even exists. Dun & Bradstreet maintains Paydex Scores for businesses, which are used to evaluate your business credit. It is important to establish and maintain business credit, says the SBA, because it can affect your ability to obtain business loans, the terms of business loans, your ability to secure supplier contracts, and helps establish a separation between business and personal finances.

Now that you know the importance of establishing business credit, how do you go about doing it? The SBA recommends taking the following actions:

  • Incorporate your business.
  • Obtain a tax identification number.
  • Apply for an identification number with Duns & Bradstreet.
  • Build credit with suppliers.
  • Keep business finances separate by opening a business bank account and applying for a business credit card.
  • Pay your bills on time.
  • Monitor your business credit score.

 

Dealing with Denial of Credit

If a lender denies you credit, you have certain rights under the law. The Equal Credit Opportunity Act requires lenders to advise you whether your application was accepted or rejected within 30 days. In addition, the lender is required to tell you the specific reason for rejecting your application, if you ask within 60 days. They must provide you with a specific reason, not just that you didn't meet their requirements.

The Fair Credit Reporting Act (FCRA) also requires the lender to give you the name, address and phone number of the credit reporting agency that supplied information in a credit report that was the basis of the denial. The credit reporting agency is required to provide you with the report information for free if you request it within 60 days of being turned down for credit. The FCRA also requires the three major credit reporting agencies to provide you with a copy of your credit report for free, upon your request, once every 12 months.