What is credit?
Understanding the Basics of Credit Score and Ways to Build/Improve It
Simply put, credit is borrowed money that you have to pay back later plus a fee for using the money. The fee associated with the money comes from the interest that the creditor/lender charges. If you ever borrowed money from a friend promising to repay them, your friend extended you credit. The difference between your friend and a creditor is that your friend most likely won’t charge you interest, however a creditor will always charge interest (that is how they make money).
CREDIT = Borrowed Money + Interest & Fees
Who provides credit?
A creditor is an entity (person or institution) that extends credit by giving another entity permission to borrow money intended to be repaid in the future. The most common creditors that you may see regularly are banks, credit unions, credit card companies, financial institutions, and payday loan companies. Creditors lend money people so that they can buy homes, cars, furniture, appliances, and other expensive items that most people do not have enough cash on hand to pay for all at once. “Lender” is just another term for creditor and means the same thing.
What is a credit score?
Your credit score is a three-digit number that creditors use to decide how likely you are to repay money on time. Your credit score is calculated by using items on your credit report, or credit history. Think of your credit score as your financial report card. In school your GPA comes from the grades you earn, and higher GPAs are rewarded the most. Similarly, a credit score comes from how you manage credit, and a higher credit score is rewarded with access to more credit at lower interest rates. Credit scores range from 300-850.
A "good" credit score is around 700 and up, but a mid-600 score is still high enough to get most types of credit. A score below 620 is typically considered a "poor" or below average, and will either be denied most types of credit or charged much higher interest rates.
Credit bureaus use your credit history to calculate your credit score. The three credit bureaus are Equifax, Experian, and TransUnion. So you technically have three different scores, because each credit bureau calculates scores slightly differently. Most lenders will only use one of these scores, or they will take your middle school and use that. So if your Equifax score is 685, Experian score is 700, and TransUnion score is 695, your TransUnion score is your middle score.
There a several factors used by the credit bureaus to determine your credit score.
1. Open Credit Utilization
Your open credit card utilization rate is your available credit compared with how much you're using at any given time. It can be calculated by taking your total open credit card balances and dividing that number by your total open credit card limits. The resulting percentage is your utilization rate.
It's important to note that your credit card utilization rate is not calculated by looking at the balance you carry over from month to month. It is calculated using the balance you have at the time that your credit card issuer reports to the credit bureau. Therefore, it is not necessary to carry over a balance from month to month. You could maintain a healthy credit card utilization through regular credit card use and paying off your balance every month.
2. Percent of On-Time Payments
Your percentage of on-time payments represents how often you make payments on time. It's often a heavily weighted factor in calculating a credit score, so just one or two late payments could significantly affect your score.
Paying bills on time is one of the best ways to keep up good credit health; it shows lenders and creditors that you're reliable and will pay back your debts.
3. Number of Derogatory Marks
These include accounts in collections, bankruptcies, foreclosures and liens. Your credit score will be severely negatively affected by a derogatory mark on your credit report. Derogatory marks typically take seven to ten years to clear from credit history, and they generally cannot be removed earlier.
A derogatory mark could severely influence your chances of getting approved for credit; it indicates to a lender that you may have significantly mismanaged credit in the past.
4. Average Age of Open Credit Lines
This factor averages the ages of your open credit cards, mortgages, auto loans, student loans and other lines of credit on your credit report. If your credit history is lengthy, lenders have more information to accurately assess creditworthiness. It's also frequently an indication that you have been able to successfully manage your credit.
For this reason, closing your oldest credit card account is typically ill-advised. It will shorten the average length of your open credit lines and reduce your available credit, possibly increasing your credit utilization rate. Think carefully about when you may want to close an old credit card account, and when you may want to avoid doing so.
5. Total Number of Accounts
This credit score factor totals up your number of credit cards, auto and student loans, mortgages and other lines of credit. Consumers with a higher number of credit accounts generally have better credit scores, since they've been approved for credit by more lenders. Also, having various types of credit--both revolving and installment--on your profile can positively contribute to your creditworthiness.
However, it's typically not recommended to open several new lines of credit simply to increase your total number of credit accounts. This factor of your credit score is usually weighed less heavily than the rest. If you are in the market to apply for new credit, make sure you first read reviews and research which product is right for you.
6. Total Hard Credit Inquiries
The final factor commonly used in your credit score is your total number of hard credit inquiries. Hard inquiries occur when a financial institution, such as a lender or credit card issuer, checks your credit in order to decide whether to approve you for a loan or credit card. A hard inquiry may occur when you apply for any of the following:
- Auto loan
- Student loan
- Business loan
- Personal loan
- Credit card
One hard inquiry could negatively affect your credit score by a few points, but the effect typically will begin to lessen after a couple of months. Multiple hard inquiries generally will more significantly impact your credit score, and can communicate to lenders that you are desperate for credit or are unable to qualify for credit. For this reason, it's a good idea to avoid applying for several lines of credit at once.
How do I improve credit?
There are a number of ways to improve your credit score. Here are some best practices and strategies for earning and keeping a high (700+) credit score.
Payment History Tips
Contributing 35% to a FICO Score calculation, this category has the greatest effect on improving your scores, but past problems like missed or late payments are not easily fixed.
- Pay your bills on time.
Delinquent payments, even if only a few days late, and collections can have a major negative impact on your FICO Scores.
- If you have missed payments, get current and stay current.
The longer you pay your bills on time after being late, the more your FICO Scores should increase. Older credit problems count for less, so poor credit performance won't haunt you forever. The impact of past credit problems on your FICO Scores fades as time passes and as recent good payment patterns show up on your credit report. And good FICO Scores weigh any credit problems against the positive information that says you're managing your credit well.
- Be aware that paying off a collection account will not remove it from your credit report.
It will stay on your report for seven years.
- If you are having trouble making ends meet, contact your creditors or see a legitimate credit counselor.
This won't rebuild your credit score immediately, but if you can begin to manage your credit and pay on time, your score should increase over time. And seeking assistance from a credit counseling service will not hurt your FICO Scores.
Amounts Owed Tips
This category contributes 30% to a FICO Score's calculation and can be easier to clean up than payment history, but that requires financial discipline and understanding the tips below.
- Keep balances low on credit cards and other "revolving credit".
High outstanding debt can affect a credit score.
- Pay off debt rather than moving it around.
The most effective way to improve your credit scores in this area is by paying down your revolving (credit cards) debt. In fact, owing the same amount but having fewer open accounts may lower your scores.
- Don't close unused credit cards as a short-term strategy to raise your scores.
- Don't open a number of new credit cards that you don't need, just to increase your available credit.
This approach could backfire and actually lower your credit scores.
Length of Credit History Tips
- If you have been managing credit for a short time, don't open a lot of new accounts too rapidly.
New accounts will lower your average account age, which will have a larger effect on your scores if you don't have a lot of other credit information. Also, rapid account buildup can look risky if you are a new credit user.
New Credit Tips
- Do your rate shopping for a given loan within a focused period of time.
FICO Scores distinguish between a search for a single loan and a search for many new credit lines, in part by the length of time over which inquiries occur.
- Re-establish your credit history if you have had problems.
Opening new accounts responsibly and paying them off on time will raise your credit score in the long term.
- Note that it's OK to request and check your own credit report.
This won't affect a score, as long as you order your credit report directly from the credit reporting agency or through an organization authorized to provide credit reports to consumers.
- Check out Reviews.com for professional reviews on credit report services to monitor your credit report & credit score.
Types of Credit Use Tips
- Apply for and open new credit accounts only as needed.
Don't open accounts just to have a better credit mix – it probably won't raise your credit score.
- Have credit cards – but manage them responsibly.
In general, having credit cards and installment loans (and paying timely payments) will rebuild your credit scores. Someone with no credit cards, for example, tends to be higher risk than someone who has managed credit cards responsibly.
- Note that closing an account doesn't make it go away.
A closed account will still show up on your credit report, and may be considered by a score.
To summarize, "fixing" a credit score is more about fixing errors in your credit history (if they exist) and then following the guidelines above to maintain consistent, good credit history. Raising your scores after a poor mark on your report or building credit for the first time will take patience and discipline.
METHODS TO INCREASE SCORE
1. Authorized User
2. Secured Credit Card
3. Self Lender
4. Removing negative items from Credit Report