Financial Literacy

Be In The Know About Credit Scores

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Understanding Credit

A credit history is a collection of all of the pieces of financial information that relate to your life. It contains information on how long you've had your individual credit accounts, the account limits, balances and your payment history. Current and future creditors only want to know one thing: If they loan you money, what are the odds that you'll repay it? The reason creditors are so concerned about how risky you are as a borrower is because when you buy something on your credit card, you're essentially taking out an unsecured loan. The loan is unsecured because you haven't put up any collateral in case you don't make payments, which means increased liability for credit card issuers.

Because how you've handled bills in the past has been proven to be a good indication of how you'll handle credit in the future, lenders obtain a copy of your credit history to take a look at this snapshot of your financial life. This gives them the information they need to decide whether to lend you money or extend credit to you.

Information in Your Credit History

In addition to listing each of your credit and loan accounts, your credit history also includes information that will identify you personally including your name, address, birth date and Social Security number. But not everything goes into a credit report. Some creditors, like landlords, many apartment complexes, some utilities and even certain lenders, don't report your payment history to the major credit bureaus (Equifax, ExperianSM and TransUnion®). So even if you have a good record of on-time payments, it won't necessarily show up on your report.

If you want to build a solid credit history, you'll want to make sure your on-time payments are reported. If the company only reports late payments and other negative information, but doesn't report on-time payments, that account may not help improve your credit history or credit score. Negative information, including any late payments, judgments, foreclosures and bankruptcies, is also typically reported to the credit bureaus. Information that seems neutral, such as what percentage of your maximum credit limit you're using, is also reported.

Your Credit Score

Each of the major credit bureaus has developed its own credit scoring system, and the three together have created VantageScore— a score which runs from 501 to 990, with 990 being the top score. However, the FICO score, developed by Fair Isaac, is used by almost 90 percent of all lenders. The FICO score runs from 300 (poor) to 850 (perfect) and the higher the score, the better your credit. According to Fair Isaac, the median FICO score is 723, meaning half of consumers fall above that and half below.

Having any negative information on your credit history will lower your credit score, but there is a statute of limitations on how long credit bureaus may keep negative information on your credit history. After either seven or ten years (the rule varies depending on the item), negative information like late payments, charged-off accounts or a bankruptcy is supposed to "fall off" your credit report. If that doesn't happen automatically, you have the right to make the bureaus remove it.

Even so, as information ages on your credit history, newer information is weighed more heavily in your credit score. That's why you can raise your credit score over time if you begin to practice good credit habits.

Check Your Credit History and Credit Score Often

Along with paying off balances and making payments on time, one of the best things you can do to protect your credit is to read your report. You're entitled to at least one free copy from each of the three bureaus every year (available at annualcreditreport.com.) Some states allow additional free reports. Obtain one copy of your credit history every four months and you should be able to keep up with your history for free. While the report is free, there is a charge to see your credit score. If you've applied for credit and were turned down, federal law says you're entitled to see that score for free. Or you can buy it at any time from any of the three national credit bureaus—Equifax, Experian and TransUnion®. 1

When you receive your credit report, go through each line to make sure the information is right. Are these your accounts? Are the balances the same as those you're seeing on your monthly bills? Does the report reflect your account history accurately (paying off balances, paying on time)? Check the personal information, too. Is that your current address? Do they have your name and Social Security number exactly right?

If you find an item that isn't yours or isn't being reported correctly, contact the bureau by phone and in writing, or go online and dispute it. The Fair Credit Reporting Act gives you the right to have incorrect information removed from your report. Be prepared to follow up until you see that the information has been removed. Credit bureaus have 30 days in which to confirm disputed information, or it must be removed from your credit history. You also may notify the creditor of any information you believe may be inaccurate or incomplete by writing to them at the address provided by the creditor. This address may be found on the back of your statement or in other documents.

Be sure to follow up and check your credit history again to ensure the fix is permanent. Credit bureaus will often remove disputed information temporarily while they investigate your complaint. By checking back, you'll ensure that the negative information or errors on your report are permanently removed.

What is a Credit Score?

A credit score is a three-digit number that represents your entire credit history. Credit scores are designed to predict how risky you will be as a borrower and what your chances are of making good on loans and other financial obligations. The scoring system analyzes how you manage each piece of credit (such as credit card accounts, mortgages or home equity loans, car loans, school loans and other debt), and then calculates your credit score based on how you've handled your debts over time.

Who invented credit scoring?

Fair Isaac was the first company to start using credit scoring on a national scale and its model, the FICO score, is the most widely used version. The scale runs from 300 (poor) to 850 (perfect), and the median score is about 723, meaning that half of consumers fall above and half fall below that mark.

How is a credit score calculated?

Different companies use different formulas to come up with a credit score. While all the formulas look at roughly the same information (things like your outstanding debts, whether you pay on time, whether you carry a balance), one formula may give more weight to certain factors than others, so different companies could assign you different credit scores.

With a FICO score, the most widely used model, these are the components that go into the calculation of your credit score:

  • Payment history: 35%
  • Amounts owed: 30%
  • Length of credit history: 15%
  • New credit: 10%
  • Types of credit used: 10%

Source: MyFICO.com1

Federal law requires that these scoring models be "empirically derived and statistically sound." So, when calculating your credit score, companies are not permitted to use certain factors, such as your marital status, religion, sex, address, health information or race to compute your credit score.

How high does my credit score need to be for me to buy a house or get a loan?

Generally speaking, the lower your credit score, the higher the interest rate you'll have to pay to borrow money. The point at which a lender simply won't make a home loan varies from lender to lender. To get a loan at going market rates (dubbed a "prime rate" loan), you want to have a score in the high 600s or above. The higher your score, the more lenders you'll have competing for your business—and the more likely it is that you'll be offered better rates and terms. If your score falls below the high 600s, you end up in what lenders call the "subprime" category. You can still get a loan, but as a sub -prime borrower, you will be offered higher interest rates and will probably see less favorable terms on your loan. In addition, not every lender will make sub -prime loans, so you may have a smaller pool of choices.

How can I raise my score (and keep it high)?

When it comes to raising or maintaining your credit score, the most important thing you can do is pay all your bills on time. If you can pay your bills in full and avoid carrying balances on your credit cards, your credit score is likely to increase. But there are a couple of little-known "secrets" that can trip people up:

Inquiries: When you apply for credit, the lender pulls your file. That's called an inquiry and it will be recorded on your credit history. Too many inquiries within a short period of time may have a negative effect on your credit history and score.

The reason: If you're applying for credit, it means you could be accumulating more debt. And from a payback standpoint, taking on more debt could mean that you'll be less able to make your other payments on time. So if you're planning for a big purchase (like a home or a car), keep excess inquiries off your credit history by not applying for other loans or opening up credit accounts while you're in the process of shopping for the loan for that purchase. And when you're shopping for that home or car loan, make all your applications within a two-week period. Then all the inquiries will count as one (as opposed to multiple inquiries), with only a five-point hit to your credit score.

Due dates: The "pay by" date is the date by which your payment must be received. When you're paying your bills, be sure to allow sufficient time for mailing to avoid a late fee. You may want to consider other payment options, such as online payments or pre-authorized debit, which are fast and free. Plus, you save money on postage.

Credit balances: High balances are bad for your credit score. If you're carrying debt, creditors reason that you can't pay it (otherwise, you would have). And the closer you come to that credit limit, the more it appears that you're struggling financially. So if you're looking to raise your credit score, keep your balances to just a small amount of your available credit.

Establishing and Maintaining Good Credit

Your credit history is a list of all the pieces of your financial life. It includes every credit card account you've opened and any other loans you've taken out. It also includes your debt repayment history. Many factors can affect your credit score, including whether you've paid on time or late, been foreclosed upon or filed for bankruptcy. If a court has ordered you to repay a loan or your debt has been deemed uncollectible—these, too, affect your score. All of this information stays on your credit history. Lenders look at your credit history to assess your ability to pay back their money. If you are having money problems, you represent greater risk to a lender. The basic principle with credit is this: use credit wisely and spend within your means.

Establishing Credit

Most young adults don't yet have credit or that much credit history established yet, but you have to start somewhere; the key is to start small. One credit card or small loan can get the ball rolling. But make sure your lender reports your on-time payments to one of the three credit bureaus— ExperianSM, Equifax or TransUnion®—and preferably to all three. If your on-time payments don't get reported, you're accumulating debt but not building credit. Only credit accounts that report your borrowing and repayment activity will count toward your credit history.

Here are some tips to help you establish a credit good history:

  • When establishing credit, pay off your charges in full at the end of the month. When you get a card, always pay off the balance in full when the statement arrives. Paying off your balance in full shows the card company that you’re fiscally responsible. You’re using credit as it was intended: as a short-term loan.
  • Pay on time. One of the most important steps in building and maintaining a solid credit history is to pay all of your bills on time each month. By paying on time, you’re showing the lender or creditor that you’ve got enough cash flow to cover your expenses. If you pay late and the creditor reports your late payment to the credit bureaus, it may damage your credit history, and lower your credit score.
  • Keep your total charges well within your credit limit. If you want to boost your credit history and credit score, you’ll want to keep your total monthly charges well within your credit limit. Why? In calculating your credit score, you’ll take a hit if your balance is above that limit because it signals to creditors that you may be having financial difficulties and thus are a riskier borrower.
  • Regularly read your credit report. One way to building a positive credit history is to make sure you know what information is being reported. Errors and negative information can damage your credit history and your credit score, so you’ll want to regularly check your credit report to see what’s there.
  • Understand what debit cards can do for you. While they look like credit cards, debit cards actually function more like a checkbook. They provide direct access to the cash in your bank account. So you can pay for items and services with a debit card instead of writing a check. What debit cards don’t do is help you build your credit history. That’s because you’re not using credit to buy these items—you’re using something that’s treated like cash. Because you’re using a cash substitute instead of credit, your debit card activity isn’t reported to the credit bureaus and won’t help you establish good credit.
  • Consider getting a secured credit card. A secured credit card is tied to an account. You deposit a certain amount of money into the account and then you can charge up to that amount. If you default on your payment, the bank can tap into the account to get repaid. After six to 12 months of on-time payments, you may feel you're ready to graduate to a regular credit card or a store card. However, resist the urge to open too many store card accounts to take advantage of discounts. Every time you open one, it results in a credit report inquiry, which may affect your score.
  • Ask for a credit line increase. After you've had your first credit card for a while (six months to a year), call the issuer and ask to increase your credit limit. The idea is to raise the credit limit on the card, not your debt load. If you're carrying a balance, raising your limit will help keep your debt-to-credit-limit ratio low. That's an important factor when calculating a credit score.
  • Focus on what you want. Your credit history becomes critical when it's time to make those big purchases, like a home or a car. At that point, a one percent difference in the interest on a loan will either cost you or save you thousands of dollars over the life of the loan.

By keeping your eye on the goal-establishing and maintaining a good credit History, you'll be able to borrow that money when you want it, and at the most favorable terms and conditions being offered.

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