Credit 101

There is so much to understand when it comes to credit. What is a
good score? What is a bad one? How can I raise my credit and what
brings my credit score down? Sometimes these things can be confusing,
and even misleading. These days many people end up with bad credit
scores simply because they didn’t know what they were doing and how
credit works. So for those of us who can’t always understand all that
legal mumbo jumbo posted on the backs of credit card applications,
here’s a short crash course in the American credit system.

Basics: What is a credit score?

Just
like the A or the F you got on your report cards in school, the credit
score is a number which is supposed to represent how well you are doing
with your credit. When your score is higher it is supposed to indicate
to lenders that you have been managing your credit well. This score is
used by banks and other financial institutions to determine the
likelihood that you will be able to pay back any money that they loan
you. The better your score then the more trustworthy, or creditworthy,
you are. If you have a good score and banks consider you more
creditworthy then they will be willing to lend you more and give you
better rates. This is how having good credit works. But if you have a
bad credit score, it can be difficult to get a new loan or credit card
which can be devastating when you really need a new house or car.

What is a good or bad credit score? 

A
good or bad score is somewhat subjective because certain companies or
people may think of some scores as good scores even if another company
may not. Generally the higher your score is then the better it is, but
it is nearly impossible to have immaculate credit. As we’ll talk about
when we discuss FICO and credit reporting agencies, there are different
ranges of credit score depending on where you get the score from. The
most popular is the FICO range, which is from 300 to 850. According to
FICO, credit scores above 770 are considered excellent and at that point
it doesn’t really matter if your score is higher you are already
considered extremely creditworthy. Once into the 700-770 range of scores
you are still considered to be very creditworthy. Think of this like an
A on your report card and a 770 is an A+. Of course, you don’t have to
have an A or an A+ to be considered creditworthy. The average credit
score for someone with good credit is around 650. 620 is where things
start to get murky though. This score is the difference between good and
bad credit. Most financial institutions consider 620 to still be good
credit, but anything lower is going to start to be not so good. There is
still some leeway with a score of around 600, but much less than that
and you are likely going to be completely denied further credit.
Anything less than around 550 is considered absolutely terrible.

How do they determine my credit score?

Your
credit score is a makeup of several different factors which are meant
to determine your creditworthiness. The most important factor is your
payment history, where companies look to see that you make regular
payments for the right amounts and check that you make those payments on
time. The second most important factor in your FICO score is the
amounts that you still owe to current financial institutions. Banks want
to make sure that you can pay them back and if you have a lot of other
things to pay back they assume it will be difficult for you to handle
paying back yet another account. Your length of credit history also
poses a significant factor in your credit report. Newer accounts are
actually more beneficial. Older accounts show banks that it takes you a
while to pay things off. FICO also looks at your lines of new credit. If
you have recently opened a lot of new lines of credit, or submitted a
lot of new credit applications this can seem desperate and negatively
affect your credit score. For more factors that can negatively affect
your credit score see our article 8 Missteps to Bad Credit.

What is FICO?  What are credit reporting agencies? 

Perhaps
the most confusing part of understanding the credit system is
understanding exactly what FICO and all the other credit reporting
agencies actually are. FICO is the most popular credit scoring agency,
and is what most lenders look at when determining your creditworthiness.
There are actually three major credit reporting bureaus: Experian,
Equifax, and TransUnion. The way these companies work is that when you
sign up for new lines of credit those lenders send your credit
information to the credit reporting bureaus. The lenders tell the
bureaus whether you make your payments on time, how much your credit
line is for, how much of your credit line you have used, and many other
things about your credit line. Then the credit reporting bureaus compile
your credit information into a database of information about all your
lines of credit. However, the problem with this is that a lot of lenders
only report your credit history to one or two of the reporting bureaus
instead of all three. Each reporting agency may have different
information on file for you depending on which lenders have sent them
your information. Regardless, unless you have managed your credit
perfectly in one account and completely ignored other accounts, your
credit score should be generally the same across all three reporting
agencies. Now that we know what the credit reporting bureaus are, we can
understand what FICO is. FICO takes the credit information provided by
these three credit reporting bureaus and creates a credit score based on
its credit scoring criteria mentioned above. FICO does not compile the
information in all three agencies to provide us with one credit score
and instead does provide us with three credit scores, one based on the
information provided from each of the three reporting agencies.

Can I get a copy of my credit score?

Because
of the Fair and Accurate Credit Transactions Act, every U.S. resident
is entitled to get a free copy of their credit report from each of the
three major credit reporting agencies every year. You are entitled to
one from each agency, which means you actually get three credit reports
per year. But this can be very misleading to consumers. The credit
reports that you are entitled to are only reports from Experian,
Equifax, and TransUnion. You are not entitled to a copy of your FICO
score, which is what most lenders use to determine your
creditworthiness. The Experian, Equifax, and TransUnion reports can be
very helpful to consumers in determining whether you need to work to
improve your credit score, since they will provide you with information
on how creditworthy you may appear to be to lenders. But in some cases
it may be more beneficial to you to purchase your FICO scores, or
purchase a score from another service. Also if you would like to monitor
your credit score more than once a year, FICO and other credit scoring
agencies offer services where you can receive monthly or quarterly
credit scores. It may be helpful to ask potential lenders which credit
scoring services they will be looking at and then go out and purchase
those exact scores.

What about services that claim you can receive a free credit report?

We’ve
all heard the catchy jingles on TV and the radio advertising free
credit reporting websites, but you should be wary of any credit scoring
or reporting service which claims to be free. Annualcreditreport.com is
the official website for ordering the annual free credit reports that
you are entitled to by law. A lot of websites that advertise free credit
reports do not give you the scores that lenders will actually be
looking at, and often only use scores and reports from just one of the
three major credit reporting bureaus. Usually these types of sites will
claim that their reports are free, but you are actually required to sign
up for a free trial of their membership service to see your score.
These sites will make it very difficult for you to cancel your
membership during the trial period, and if you don’t cancel soon enough
you will be charged for a monthly membership until you do cancel. Even
if you do manage to cancel your monthly membership without incurring any
fees, these types of websites will often spam your email inbox long
after you have cancelled. Be sure to look closely at the fine print for
any “free” credit report website before you sign up and look for reviews
online before you buy.

Now that you know the basics of the
credit industry, you can make informed decisions about what types of
credit are right for you and how to manage your credit wisely.  Be sure to look into all of your credit options before making final decisionsBusiness Management Articles, and keep track of your credit score regularly.

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