What is credit?
Everywhere you look there are articles extolling the virtues of good credit. Everyone wants it but do you really know what it takes to achieve and maintain good credit? Do you even really need Credit? Many financial gurus who will tell you that if you pay with cash then you don’t need credit. Unfortunately, for the majority of people this is not always a feasible option. Perhaps a couple of decades ago this would have been sound advice. However these days credit profiles are being used for more than just credit cards and car loans.
Credit scores are used to determine if someone would be a good employee. For car insurance rates as well as determining if one can rent an apartment or activate utilities. With so many facets of our lives being based on credit scores it is important that to understand what it is and how it works. With this information you will be equipped to manage it wisely.
How are credit scores calculated?
A credit score is a three digit score that is used to predict your ability to pay future debts based upon past performance. These scores can range, on average, from 300 to 850. The higher the score the more attractive you are to lenders. These numerical scores are weighted based on these 5 categories: Payment History, Amounts Owed, Age of Credit, Credit Inquiries and Types of Credit.
Payment History
As you can see in the above chart payment history and the total balance you carry on your credit cards and loans make up well over half of your total score. One late payment can send your score into a 10+ point tailspin. Multiply that late payment by more than one account or over a series of months and this can cost you thousands of dollars in interest fees.
Credit Utilization
Not paying your credit cards in full every month is not a huge problem for your credit score unless you keep a balance above 30% of your available limit. If you keep a balance of between 50%-90% you will also see a significant drop in points. You may also be denied new credit based on this usage. Creditors view continuous balances over 30% as an indicator that you may not be using credit responsibly. While they may still extend credit to you it would be with lower credit limits and higher interest rates.
If you are paying your bills on time and pay your balances in full or stay below thirty percent on your balances, you may still have a hard time getting into the 650-750 range based on the remaining 3 factors. These three factors combined make up a large part of your score and are harder to change quickly. These categories are time specific and can’t easily be changes.
Other Credit Factors
Age of Credit
The amount of time that you have had credit in your name is dependent on how old you were when you opened your first card. For most people the earliest they can legally have their own credit is 18. That means that if you are a 21 college graduate and looking to purchase a car your score may suffer because you haven’t established a long enough positive payment history.
The only exception to this rule is if you are added as an authorized user on the account of someone with a long positive payment history, like a parent. When this happens you will inherit their payment history which will boost your score. You will want to be very careful about doing this because it works both ways. If their payment history takes a turn for the worst then you will inherit that as well.
Credit Inquiries
The credit inquiry category of the credit score reflects how many times you have applied for new credit in 12 month period. Applying for 1-2 items per year is considered excellent. Anything more than that and it will begin to adversely affect ten percent of your total score. In order to not penalize people who are shopping around for mortgage rates or car loans all inquiries made within a 30 day span from the same type of industry will only count as one inquiry. When you are house hunting or purchase a new car make sure that you apply in the same time frame to avoid taking a larger hit to your credit.
Types of Credit
The final credit category is Credit Mix or the different types of credit that you have. Having a lopsided credit profile can negatively affect your credit as well. If you have one credit card and no history of installment loans then this is counted against you and can ding your credit 10 percent. Credit agencies want to see that you have the ability to properly manage different types of credit like car loans, mortgages and credit cards, effectively.
This does not mean that you have to go out and get all of these different types of loans in order to be considered credit worthy. Demonstrating an ability to manage a variety of credit is viewed as a benefit and makes you a less risky consumer.
Put this knowledge to work for you
There are three major credit bureaus, Transunion, Equifax and Experian. When you apply for credit the company you submit your application to gets a report from one of these agencies. To make things even more interesting they each calculate and weigh your information the differently. Not all companies report to all three agencies so your score can vary greatly from one agency to another. There is no guarantee of accuracy so it is very important that you monitor your reports at a minimum every 12 months.
With so many facets of your life being influenced by your credit rating, it has never been more important for you to know your score. You are entitled to a free copy of your report from all three agencies once per year. The best way to stay on top of the information that is reported is to monitor it. Click here for your free credit reports.
How can you improve your score?
Join us for next week’s post. We will provide strategies for improving your credit. Whether you have no credit, good or bad credit, join us for strategies for improving and maintaining it.