How Credit Reporting Agencies Work

Lending money is risky business. Remember that time your friend Bob borrowed $50 and said he'd pay you back the next day? You haven't seen Bob or your $50 in three years. If you had known that Bob had a long history of borrowing money from friends -- and not paying them back -- you probably wouldn't have lent him the cash in the first place.

Large lending institutions like banks, mortgage companies and other creditors take the same risk when they give loans to consumers for buying homes, financing cars and paying for a college education. Creditors attempt to minimize the risk of these loans by carefully examining the credit history of borrowers. If a borrower has a bad credit history, then the lender might not give him a loan, or may charge him a higher interest rate.

If you've ever owned a credit card or applied for a loan, then you have a credit history. Your credit history is compiled and maintained by companies called credit reporting agencies or credit bureaus. Credit reporting agencies collect your credit history from credit card companies, banks, mortgage companies and other creditors to create an in-depth credit report. The information in that report is also used to calculate a three-digit credit score.

Every time you apply for credit, the bank or credit card company calls up one or more of these credit reporting agencies to review your credit report and credit score. The lending institution will decide whether to extend you a loan -- and at what interest rate -- largely based on the credit history reported by those agencies.

Credit reporting agencies are powerful institutions. One bad entry on your credit report can cripple your borrowing power for years. Even worse, credit reports are often requested by employers, landlords and insurance companies. That's why it's so important to make sure that everything on your credit report is true and accurate. According to a 2004 study, one out of every four credit reports contains serious errors: debts wrongfully listed as delinquent, closed accounts listed as open, debts that belong to other people with the same name, et cetera [source: MSNBC].

For decades, the information collected by credit reporting agencies was hidden from consumers. Individuals had no idea why they were denied credit or whether or not their reports contained mistakes. Beginning with the Fair Credit Reporting Act in 1971 and continuing with recent legislation, U.S. citizens have free access to their credit reports and credit scores from each of the three national credit reporting agencies: Experian, TransUnion and Equifax. Citizens also have the right to know exactly why their credit was denied.

In this HowStuffWorks article, we'll explain how the "Big Three" credit reporting agencies work, your rights when dealing with them, and how to protect yourself against errors and fraud.

Let's start with the Big Three.

The Big Three

Experian, TransUnion and Equifax -- also known as the "Big Three" -- are not the only credit reporting agencies in the United States; they're just the biggest. According to the Consumer Data Industry Association, an international trade organization that represents credit reporting agencies, there are dozens of smaller, regional and industry-specific credit bureaus that provide clients with credit reports and other "risk-management" services [source: CDI Online]. There are also many international credit reporting agencies that focus on one country or region.

The Big Three get all the attention because they maintain the largest national databases of consumer credit information. Experian, for example, boasts that it maintains credit information on 215 million American consumers [source: Experian]. That's over two-thirds of the total U.S. population [source: U.S. Census].

The Big Three perform two basic services: collecting and reporting credit information. Here's how The Big Three collect credit information:

Every month, lending institutions and other creditors send updated consumer credit information to one or more of the Big Three credit reporting agencies. This information includes how much individual consumers owe and whether they make their payments on time.
Whenever you fill out an application for a credit card or a loan, all of that information (like income figures) is also sent to the credit reporting agencies.
The Big Three also scour public records for financial information, such as court records from bankruptcies and foreclosures.

[source: PBS]

The same lending institutions that supply information to credit reporting agencies also request reports when a consumer applies for credit. Individual consumers can request copies of their credit reports and credit scores, as well. Here's how credit reporting agencies share information with consumers and creditors:

Credit reporting agencies only share credit reports and scores when there's a request, formerly called an inquiry.
There are two kinds of inquiries: hard and soft.
Hard inquiries are requests made by institutional creditors like credit card companies and mortgage lenders and by rental applications to a landlord [source: Credit.com]. Soft inquiries are made by the consumer himself or by an employer.
Negative events like bankruptcies and foreclosures stay on a credit report between 7 and 10 years, while positive events, like on-time mortgage payments, can stay on even longer

[source: Truecredit.com]

It's important to remember that the Big Three credit reporting agencies are independent companies that each collect information in different ways. Therefore, a credit report from Experian will contain slightly different information than a credit report from TransUnion, which will differ slightly from Equifax. Not every creditor and lending institution reports to all three credit bureaus, leading to further discrepancies.

For more information on how credit reporting agencies compile credit reports and calculate credit scores, see How Credit Reports Work and How Credit Scores Work.

Now let's talk about credit reporting agencies and your rights.

Credit Reporting Agencies and Your Rights

As we mentioned earlier, credit reporting used to be a closed system. Consumers had no idea what information was on their credit report, why they were denied credit or if their credit reports contained mistakes. Also, in the past, credit reports only contained negative credit events, not positive information. They were also allowed to share "lifestyle" information about consumers, like sexual orientation and reported problems with drugs or alcohol [source: PBS].

In 1971, the U.S. congress enacted the Fair Credit Reporting Act, the first legislation protecting the rights of consumers when dealing with credit reporting agencies. U.S. citizens, under the Fair Credit Reporting Act, have a right to:

a complete copy of your credit report (for a fee)
a free copy of the report with the negative information, if you're denied credit
know exactly who has requested a copy of your credit report in the past six months
report errors on a credit report and have the credit reporting agency respond within 30 days
have proven errors removed within 30 days
add comments to your credit report to tell
have negative credit events removed from your report after 7 to 10 years
restrict access to your credit report and block credit reporting agencies from selling your information to credit card companies and other marketing firms

[source: Credit.com]

The Fair and Accurate Credit Transactions Act of 2003 (FACTA) goes even further, giving U.S. citizens the right to request one free copy of their credit report from each of the Big Three credit reporting agencies every year. FACTA also includes several provisions protecting against the growing problem of identity theft, which we'll talk about in the next section.

Here's how you request a free copy of your credit report, as established by FACTA:

You can request a report by phone at (877) 322-8228, online at www.annualcreditreport.com, or by mailing this request form to the following address: Annual Credit Report Request Service P.O. Box 105281 Atlanta, GA 30348-5281
At annualcreditreport.com, select your state from the pull-down menu and press "request report."
On the following page, enter your personal information (name, birth date, social security number and current address).
You will then be asked to choose from which of the Big Three credit reporting agencies you want to request a report. You can choose to request a report from a particular agency or from all three (remember, you can request one copy from each CRA once every 12 months).

The free annual copy of your credit report doesn't include your credit score, which can be purchased directly from the individual CRAs for around $6. You can also purchase as many credit reports as you want from each of the Big Three CRAs. The price for a basic credit report is under $10.

Now let's talk more about errors and fraud related to credit reporting agencies.

Impostor Credit Reporting Sites

According to a 2005 report, the World Privacy Forum found 112 "imposter" Web sites that contain domain names similar to annualcreditreport.com or that take advantage of common misspellings [source: World Privacy Forum]. Some of these sites ask for highly sensitive information like names, social security numbers and addresses to steal a consumer's identity and apply for credit in his name. To avoid these scams, the World Privacy Forum recommends that consumers order their free annual credit report by phone, not online.

Errors and Identity Theft

In 2004, the Public Interest Research Group (PIRG) studied nearly 200 credit reports and found that 79 percent of them contained mistakes, many of them serious [source: MSNBC]. With over 4.5 billion pieces of data collected each month by credit reporting agencies, there's a lot of room for error [source: PBS].

Here are some of the most common credit report errors, according to PIRG:

Different credit reports associated with different addresses. They both use your name, but only contain partial information.
Your report contains information on someone else with your same name.
Information is reported twice, either positive or negative credit events.
Public record information is wrong. They include court records and bankruptcy reports that are wrongfully associated with you.
Your credit card company fails to report your credit limit. When that happens, the credit reporting agency uses your highest reported balance as your credit card limit. How does this hurt you? Your balance looks high as a percentage of your credit limit, when in fact it might be much lower.
Erroneous information caused by identity theft.

[source: PIRG]

Identity theft is one of the most common and costly crimes in America. Although individual instances of identity theft have actually gone down in recent years -- 9.3 million in 2005 to 8.4 million in 2007 -- all it takes is one case to destroy your credit for years [source: Privacy Rights]. For more information, read our article on How Identity Theft Works.

Credit reports are one of the best tools for discovering identity theft. Many people don't know they've been victims of identity theft until they find suspicious activity on their credit reports. That's why it's recommended that you request a credit report at least every six months. Here are some things to look for:

Account names and numbers you don't recognize
Loan applications you don't remember filling out
Addresses where you haven't lived
Soft inquiries by employers or landlords you don't recognize

[source: Federal Reserve Bank of Boston]

To combat identity theft, some credit reporting agencies offer a paid service called credit monitoring. With this service, the CRA notifies you immediately of any inquiries or changes to your credit report, while keeping an eye out for any suspicious activity. Another technique is to monitor your credit yourself by requesting a free copy of your credit report every four months from one of the Big Three CRAs.

If you find a mistake on a credit report, notify each of the Big Three CRAs immediately.

We hope this article has helped you understand the importance and influence of credit reporting agencies. For more information on credit reporting agencies, debt and related topics, check out the links on the following page.

How Credit Reporting Agencies Work

The Big Three

Credit Reporting Agencies and Your Rights

Errors and Identity Theft

Lots More Information

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