A Complete Guide To Understanding Credit

A Guide To Understanding How Credit Works

If you’re ready to take the next step in your financial journey, understanding credit is a crucial first step. Knowing how and why it works — as well as knowing the tips for building a healthy credit history — can open up new opportunities both now and in the future. Whether you are looking to buy or rent, establishing good credit habits provides greater control over your life by helping ensure access to funds when needed.

What Is Credit and How Is It Used?

Credit, in financial terms, refers to the trust that allows one party to lend resources to another, with the understanding that the borrower will repay the lender at a later date, often with interest. This system plays a fundamental role in the world's economies by providing individuals and businesses with access to necessary funds that they may not have on hand.

There are multiple types of credit, including revolving credit (like credit cards), installment credit (like auto loans or mortgages), and open credit (like utility bills). These forms of credit are used in various ways depending on the needs and financial capabilities of the borrower.

Credit is used for a multitude of purposes, such as purchasing a home, financing a vehicle, starting a business, or even just buying dinner. Credit allows individuals to make purchases or investments without immediate expenditure, thereby enabling financial flexibility.

A borrower's creditworthiness — their ability and willingness to repay debt — plays a vital role in obtaining credit. Lenders determine this through a credit score, a numerical expression based on an analysis of a person's credit files. A higher score indicates a lower risk, making lenders more likely to extend credit. We'll delve deeper into the intricacies of credit scores in the following sections of this guide.

How Credit Can Effect Your Payment

Let's take a practical example to illustrate how your credit score can impact the amount you pay on a loan.

Consider you're applying for a 30-year fixed-rate mortgage for $200,000. If you have a high credit score, say 760 or above, you might qualify for an interest rate of 3.5%. This would result in a monthly mortgage payment of about $898.09 and the total interest paid over the life of the loan would be approximately $123,372.

On the other hand, if your credit score is lower, say around 620 – 639, you might be offered a higher interest rate, say 5.1%. In this case, your monthly mortgage payment would be about $1,083.37, and the total interest paid over the course of the loan would be approximately $190,013.

In this example, a lower credit score could cost you an additional $185.28 per month and an extra $66,641 in interest over the life of the loan. Thus, maintaining a good credit score can save you a substantial amount of money in the long run.

Understanding Your Credit

To fully understand your credit, you need to familiarize yourself with your credit report and credit score, as these are the primary tools lenders use to assess your creditworthiness.

Understanding your credit involves regularly reviewing your credit report, ensuring the information is accurate, and addressing any errors promptly. Furthermore, maintaining good credit habits such as paying bills on time, keeping low balances on credit cards, and applying for new credit only when necessary can significantly improve your credit score over time.

It's also important to remember that all credit inquiries — whether from lenders or other companies — can lower your score. As such, it is wise to limit the number of times you apply for new credit, as this can have a negative impact on your creditworthiness.

Difference between a Credit Report and a Credit Score

A credit report and a credit score, though related, serve different purposes in the credit evaluation process. A credit report is a detailed document that lists an individual's credit history. It includes information about current and past credit accounts, payment history, public records such as bankruptcies, and inquiries from potential lenders. These reports are prepared by credit reporting agencies and provide a comprehensive view of an individual's credit activity.

On the other hand, a credit score is a numerical representation derived from one's credit report. It's a three-digit number that lenders use to assess the risk of lending to an individual. A higher score indicates a lower risk to the lender. It's based on several factors found in the credit report, including payment history, amounts owed, length of credit history, new credit, and types of credit used. The most common type of credit score in the United States is the FICO score, with scores ranging from 300 to 850.

How to Pull Your Credit Report for Free

Obtaining a free copy of your credit report at regular intervals is crucial to understand the current status of your credit and to monitor any discrepancies. In the United States, the Fair Credit Reporting Act (FCRA) mandates each of the major credit reporting agencies — Experian, TransUnion, and Equifax — to provide consumers with a free copy of their credit report once every 12 months. Here's a step-by-step guide to pull your free report:

1. Visit AnnualCreditReport.com: This website is the only federally approved portal for obtaining your free annual credit report.
2. Fill out a request form: You'll need to provide personal information, including your date of birth, Social Security number, and current and previous addresses.
3. Choose a credit reporting agency: You can request a report from one or all three of the major credit bureaus.
4. Answer security questions: These are designed to verify your identity and can involve questions about your financial history.
5. Download or print your report: Once verified, you can view your report immediately. It's a good idea to save a digital copy or print it for future reference.

Free Credit Score Sources

In addition to pulling your credit report, staying updated about your credit score is equally essential. There are various online platforms where you can check your credit score for free. Here are a few:

1. Your Banking Institution: Some banks and credit unions offer their customers free access to their credit score.
2. Credit Card Issuer: Many credit card companies provide access to your credit score.
3. Financial Services Companies: Many personal finance services, such as Mint, Credit Karma, and NerdWallet, allow you to check your credit without a fee.
4. Capital One CreditWise: You don't have to be a Capital One customer to use CreditWise. This tool provides free credit score checks and alerts for any potential fraud.

Remember, these platforms provide educational credit scores. Lenders might use a different scoring model when checking your creditworthiness.

Credit Scoring Models

There are several credit scoring models used by lenders, credit card issuers, and other financial institutions to assess a consumer's credit risk. Here are a few dominant ones:

1. FICO Score: Developed by the Fair Isaac Corporation, the FICO Score is one of the most commonly used credit scoring models. It ranges between 300 and 850, with a higher score representing lower credit risk.
2. VantageScore: This model was developed collaboratively by the three major credit bureaus – Equifax, Experian, and TransUnion. Similar to FICO, VantageScore also uses a scale from 300-850.
3. PLUS Score: Exclusively for educational purposes, the PLUS Score is used by individuals to understand their credit score. It's not used by lenders for credit decisions.
4. TransRisk Score: Developed by TransUnion, this score also helps consumers get a sense of their creditworthiness.

Remember, different lenders might use different scoring models or their customized versions. Therefore, the scores from these models may not match the exact score used by a lender to assess your creditworthiness.

What is Good Credit?

Good credit is more than just a number; it's an indication of financial health and trustworthiness. A good credit score generally falls between 670 and 800 according to the FICO scoring model, or between 700 and 850 on the VantageScore scale. Having a good credit score demonstrates to lenders that you are reliable in managing and repaying your debt, making you a favorable candidate for loans or credit cards. It can lead to benefits like lower interest rates, higher borrowing limits, and more favorable loan terms. Maintaining good credit involves consistent, responsible financial behaviors such as timely bill payment, maintaining a low credit utilization ratio, limiting new credit applications, and regularly reviewing your credit report for accuracy.

What is "Bad" Credit?

"Bad" credit, also known as poor credit, refers to a credit score that is low enough to negatively impact your ability to secure loans or obtain credit from financial institutions. Typically, a FICO score below 580 and a VantageScore below 601 are considered "bad". These low scores may indicate a history of missed payments, frequent borrowing, or high credit card utilization. It's important to note that different lenders may have different thresholds and interpretations of what constitutes "bad" credit. Remember, a "bad" credit score isn't permanent and can be improved with disciplined financial practices, like paying bills on time and keeping credit card balances low.

Causes of Bad Credit

Bad credit can be caused due to numerous factors, often related to financial behaviors and decisions. The most common causes include:

1. Late or Missed Payments: Your payment history is a significant factor in your credit score. Late or missed payments on credit cards, loans, or bills can have a substantial negative impact on your credit score.
2. High Credit Utilization Ratio: This refers to the percentage of your available credit that you're currently using. If it's high, lenders may perceive you as overly reliant on credit, which can negatively affect your score.
3. Frequent Borrowing: Regularly applying for new credit, such as loans and credit cards, can lead to a series of hard inquiries on your credit report, which may lower your score.
4. Defaults and Bankruptcy: More serious events like defaults, foreclosures, or bankruptcies have a more severe impact on your credit score and can take longer to recover from.
5. Incorrect Information: Errors on your credit report, such as wrong accounts or incorrectly reported missed payments, can also lead to a lower credit score.

Be proactive in understanding these factors and their impact on your credit score. With mindful financial habits, you can avoid damaging your credit and work towards improving it if it's already low.

How To Raise Your Credit Fast

Improving your credit score quickly requires discipline, strategy, and a good understanding of credit scoring models. Here are some effective strategies:

1. Pay Your Bills On Time: Late payments can significantly lower your credit score. To avoid this, set up payment reminders or automatic payments for your bills.
2. Pay Down Debt: High levels of outstanding debt can negatively impact your credit score. Try to pay off your debts as quickly as possible and keep your credit card balances low.
3. Avoid New Debt: Try not to open new credit accounts unless necessary, as this could indicate increased risk to lenders.
4. Check Your Credit Reports for Errors: An error on your credit report can lower your score. Regularly review your credit reports from each of the three major credit bureaus and dispute any inaccuracies you find.
5. Maintain Older Credit Accounts: The length of your credit history can affect your score. Try not to close old credit cards, even if you don't use them often.

Remember, while these are general strategies that help you raise your credit score, there's no instant fix for bad credit. Improving your credit health is a long-term commitment that requires continuous effort.

Mistakes to Avoid When Trying to Improve Your Credit

Improving your credit score is an important financial goal, but certain missteps can hinder the process. Here are some common mistakes you should avoid:

1. Applying for Multiple Credit Cards at Once: Too many credit inquiries in a short period can negatively impact your credit score. Instead, space out your applications over time.
2. Ignoring Your Credit Utilization Ratio: This is the ratio of your credit card balance to your credit limit. Keeping this ratio low (usually under 30%) can positively influence your credit score.
3. Closing Unused Credit Cards: Contrary to popular belief, closing unused credit cards can harm your credit score. This is because it reduces the amount of credit available to you and increases your credit utilization ratio.
4. Ignoring Your Credit Report: It's crucial to regularly monitor your credit report to identify and rectify any errors or fraudulent activities.
5. Relying on Minimum Payments: While making minimum payments can help avoid late fees, it doesn't significantly reduce your debt. Try to pay more than the minimum whenever possible.
6. Paying off Old Debt: One might think that paying off old, potentially forgotten debt is a good idea, but this isn't always the case. Settled accounts stay on your credit report, and the date of last activity updates to become more recent, which can harm your credit score. Before deciding to pay off old debt, consult with a credit counselor or financial advisor to understand the potential implications

Beware of Scammers:

In today's digital world, it's essential to be vigilant against scammers. Always keep your personal and financial information secure and never share it via email or over the phone. Regularly update your passwords and consider using a password manager for extra security. Don't respond to unsolicited calls or messages asking for your credit card details or other personal information. Always verify the identity of the caller and the legitimacy of the institution they claim to represent. Keep in mind that legitimate financial institutions will never ask for your personal information through insecure channels. Also, consider investing in identity theft protection services, which can monitor your credit and alert you to suspicious activities.

Conclusion

In conclusion, maintaining a good credit score requires discipline, informed decision-making, and constant vigilance against fraud. It's important not only to manage your debts wisely but also to be aware of the implications of your financial actions. Ensure you are regularly checking your credit report and stay alert for any signs of fraudulent activity. The journey to financial health is ongoing, but with careful navigation, the benefits can be significant and long-lasting. Remember, a strong credit score is your ticket to securing your financial future, so make it a priority.