Credit Ratings:
What is it?
Credit is simply the reputation for repaying your debts on time. The better your credit is, the more willing people and companies are to lend you money for various items and issue you credit cards.
You don’t need a perfect payment history to have good credit, but having poor credit can often be difficult to escape. Applying for a credit card or personal loan requires a credit check by the lender you wish to borrow from. They do this to asses whether or not you are a good credit risk by looking at your credit score.
By looking at a credit score, lenders can view your bill-paying history, number and type of accounts you have, late payments, collection actions, outstanding debt, and the age of your accounts. A credit score is determined by points that are awarded by a credit scoring system. This all shows up on your credit report.
You can obtain one free copy of your credit report every 12 months through Experian, Equifax, or TransUnion. These are the three major credit-reporting agencies in the U.S. They each use a different scoring model to come up with your rating, so it is important to see all three. Annualcreditreport.com can give you more details on getting your free reports.
Why it's critical
Your credit report is critical. Your ability to borrow money is based heavily upon credit - whether you want a loan, a cellphone, a home, a car (or a college loan), it is very important to make sure your credit is accurate before you submit a credit application.
The good news is that the Federal Fair Credit Reporting Act (FCRA) requires each of the major nationwide consumer reporting companies to provide you with a free copy of your credit reports, at your request, once every 12 months.
Overall, credit scores are a good thing. They give lenders a fast, objective view of your credit risk. They ensure the credit-granting process is not slow, inconsistent or unfairly biased. Because of credit scores:
- People can get loans faster, up to and including "instant approval" for lenders who use only FICO® scores to make a decision.
- Credit decisions are fairer.
- Credit "mistakes" count for less - they are offset by "good" credit items and eventually come off your report.
- Credit costs are lower because lenders make better decisions and absorb less default/bad debt.
So what is a credit score anyway?
Information about you and your credit, like your bill-paying history, the number and type of accounts you have, late payments, collections, your overall debt, and how long you’ve had credit accounts, are all part of your credit report. Creditors compare this information to the statistics of other consumers with similar information to yours. You get points for behavior that statistically indicates you are likely to repay. You lose points for behavior that indicates the opposite, and a number is generated.
- Your "credit score" is called a "FICO®" score by the finance industry. FICO® scores are used by most lenders to evaluate your credit risk.
- You have three FICO® scores, one from each credit bureau - Experian, TransUnion, and Equifax. The score is based on the credit bureau’s information about you. As this information changes, your credit scores change too.
- Particularly critical for students is the concept of a "thin file." Thin File is industry jargon for someone without a long credit history. This becomes critical because thin file credit scores can change significantly based on one or two items. Think of it this way ... If you’ve paid all your bills on time for 40 years and you pay late once (late 0.01% of the time), it won’t affect your credit score that much. BUT, if you’ve paid all your bills on time for 4 months, and you’re late for month 5 (late 20% of the time) that can dramatically affect your score. Students and younger people must be especially concerned about not doing anything to harm their credit score.
- FICO® scores don’t just impact whether you can get credit, but what it costs. Those with higher FICO® scores pay lower interest rates and fees. Those with lower FICO® scores pay higher interest rates and fees (if they can get credit at all).
What affects it?
FICO® scores are calculated from many different items in your personal financial history. But, this data falls into five main categories, which affect your credit in different ways. Generally speaking, each of the five categories contributes to your credit score in the following percentages:
- Payment History: 35%
- Amounts you owe: 30%
- Length of Credit History: 15%
- New Credit: 10%
- Types of Credit used: 10%
These percentages are based on the general population. For students who have not been using credit long - the percentages may be slightly different.
What’s included in each category?
Payment History
- Account payment information on credit cards, retail accounts, installment loans, mortgage, etc.?
- Negative public records (bankruptcy, judgments, suits, liens, wage attachments, etc.), items in collection and delinquencies (unpaid, past-due items)?
- Length of delinquency (how long past due - is it 6 months overdue, or 60 days)?
- Amount of delinquencies or collections - it’s worst to default on $100,000 than on $100.
- When were past-due items, negative public records, or collection items added to the record (longer in the past is better)?
- How many past-due items on file?
- How many accounts paid as agreed?
Amounts Owed
- How much do you owe on accounts?
- Specific types of accounts matter, for example unsecured versus secured loans.
- How many accounts do you have where you carry balances?
- How much of your credit lines you use? (Does your $1,000 credit card have $1,000 charged on it? Or $50?)
- How much of your installment loan amounts do you still owe? (If you borrowed $10,000 to buy a car, do you still owe $9,000 or $500?)
Length of Credit History
- How long since accounts opened?
- Again, specific type of account can affect your credit differently.
- How long since there was activity on the account?
New Credit
- How many accounts have you opened recently, and what proportion of your total credit do they represent? (Generally a high proportion of new accounts will reduce your score.)
- How long since your recent accounts were opened?
- How many recent credit inquiries?
- This one is important!!! If you go out and apply for many, many loans just to see what you’ll get, you’re actually reducing your credit rating!
- How long since these credit inquiry(s)?
- Have you rebuilt positive credit history following past payment problems? (This is a good thing.)
Types of Credit Used
- How many different types of accounts? (credit cards, retail accounts, signature loans, installment loans, mortgage, HELOC, consumer finance accounts, etc.)
Lenders do look at many things to make a credit decision about you, often including your income, how long you have worked at your present job and the kind of credit you are requesting. But credit score is very important indeed.
How to get/keep good credit
There are no shortcuts. Raising your score takes time. You should, in fact, be very dubious about anyone who claims they can "fix" your credit quickly - such efforts can actually backfire and hurt your credit.
Credit Score Tips
- Start at the beginning: don’t spend more than you can afford.
- Pay your bills on time.
- If you have missed payments, get current and stay current.
- If you are having trouble making ends meet, contact your creditors.
- Keep balances low on credit cards.
- Pay off debt rather than moving it around.
- Don't close unused credit cards as a short-term strategy to raise your score. Closing an account doesn't make it go away.
- Don't open a number of new credit cards that you don't need just to increase your available credit. Especially if you have a "thin" file, you should not open a lot of new accounts too rapidly.
- Do have credit cards, just manage them responsibly.
- Do any "shopping" for a given loan within a focused period of time.
- Re-establish your credit history if you have had problems by slowly opening a few new accounts and keeping them current.
- It's OK to request and check your own credit report. This doesn’t count toward your "how many inquiries?" factor.
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