Check Your Credit History Before Applying for a Loan
By Mark Kantrowitz
It is a good idea for students and parents to review their credit reports for errors and to correct any errors before applying for a private student loan, private parent loan or private consolidation loan.
Eligibility for these loans depends on the credit scores of the borrower and cosigner (if any). The credit scores can also affect the loan's interest rates and fees. The lenders of private student loans use the higher of the two credit scores to determine eligibility and the interest rates and fees. Lenders may also review the detailed credit history of the borrower and cosigner, looking for red flags as part of the credit underwriting process.
What is a Credit Score?Credit scores summarize the information in the credit history and rate the odds that the borrower will repay his or her debts on time.
The FICO score, a popular credit score developed by Fair Isaac Corporation, is reported on a scale from 300 to 850, with higher scores indicating a lower credit risk. Credit scores below 650 are considered subprime. (Other credit scores like the VantageScore use a different numeric scale.)
About a third of the credit score is based on your payment history and about a third from amounts owed, with the rest split among length of credit history, types of credit used and new credit.
When a borrower applies for a loan, it results in a hard inquiry on the borrower's credit report. A hard inquiry results from an attempt to obtain new or increased credit and can reduce the credit score by about 5 points. However, the credit bureaus recognize when borrowers are shopping around for the best interest rate, so several applications in a short period of time will be treated as a single inquiry.
How Lenders Use Credit ScoresLower credit scores correspond to a higher risk of default. If a lender prices the loans to yield equal revenue net of defaults, even a 20% risk of default can be the equivalent of adding 4-5 percentage points to the loan's interest rate on a 10-year term.
Typically, a lender will group credit scores into ranges called tiers, with each tier corresponding to a specific interest rate and fees. The lowest tier may have an interest rate that is as much as 6% percentage points higher than the highest tier, potentially causing borrowers to pay twice as much interest over the life of the loan. The lowest advertised interest rate is usually available to less than 10% of borrowers.
Free Copies of Credit ReportsTo get a copy of your credit report from each of the three major credit reporting bureaus, visit www.annualcreditreport.com. This web site can be used to get a free copy of your Equifax, Experian and TransUnion credit reports once every 12 months. Review all three credit reports for errors, since each lender may review only one credit report. These credit reports do not currently include credit scores.
The credit scores provided by free web sites like CreditKarma and WalletHub aren't necessarily the same as the ones used by lenders, but are similar in concept. The CreditKarma and WalletHub web sites also provide tools for understanding how to improve your credit scores and personalized savings.
Buying Copies of Credit ReportsConsumers can also buy copies of their credit reports directly from the credit bureaus. These credit reports will include the credit scores. Some provide an ongoing credit monitoring service or other services for a monthly fee. If you are not interested in these services, be careful to cancel the service after you receive your credit report and scores.
One can also get free copies of actual credit scores from some credit card issuers and education lenders.
Correcting Errors in Credit ReportsErrors in the credit history can lead to a lower credit score. If an incorrect address is listed in the credit history, it can be a sign that someone else's credit history has been merged with your credit history. Also, look for errors in the reporting of on-time payments, since a delinquency or default can cause a big drop in your credit score. Are any accounts missing? Are there any accounts you don't recognize?
To correct errors in your credit reports, dispute the inaccurate information in writing. Include your name, account number and details about the disputed information in the dispute letter. Providing documentation that demonstrates that the information is inaccurate will be more effective than merely asserting that the information is inaccurate. Send the dispute letter by certified mail, return receipt requested, to both the credit bureau and the creditor that provided the inaccurate information. Any inaccurate information that cannot be verified by the creditor will be removed from your credit report.
How to Improve Credit ScoresImproving your credit scores takes time. There are no quick fixes, other than removing incorrect negative information.
The best way to get a better credit score is to make all payments on all debts (not just the student loans) on time and in full every month for an extended period of time. Never be late with a payment and avoid serious delinquencies of 90 or more days. Signing up for auto-debit, where monthly payments are automatically transferred from your bank account to the creditor, is one of the most effective ways of ensuring that bills are paid on time.
Revolving credit, like credit cards, can have a big impact on your credit score. Try to minimize the use of credit cards. Pay down or pay off the balance on your credit cards to reduce your credit utilization. Do not borrow close to or beyond your credit limit. Do not carry a balance on your credit cards. Don't cancel the credit card account, but instead charge something to the account every few months to keep it active.
Resist the temptation to continually open new accounts. Having too many new accounts will hurt your credit score.
If your credit history shows a delinquent account, don't pay it off and cancel the account. Instead, bring the account current and keep it current. This will switch the account from being an ongoing source of negative information to being an ongoing source of positive information. Eventually, the delinquency will be pushed off the end of the credit report. Also, as time passes, the delinquency won't be weighted as heavily.
Try to avoid adding any derogatory events, such as bankruptcy discharge, foreclosure and repossession, to your credit history. Such derogatory events act as red flags that can prevent you from being approved for a loan. Do not file for bankruptcy except as a last resort. These derogatory events will remain on your credit history for at least seven years.