What is credit? Almost all of your big purchases in life, whether it’s a house, car, student loans, or a computer, will depend upon your credit. A three-digit number – your credit score – will determine whether you will be able to make these purchases and for how much. Many people believe that if you pay your bills on time you will have a good score. While this is one of the driving factors of having a good score, there is much more that accounts for the overall value. In this article we will put together a quick guide on how credit reports work, what determines your score, and how you can go about improving that three digit number.
Before we can dive in and talk about credit scores, it is important that you know how credit reports work. Your report is an accumulation of information on how you pay your bills and repay your loans, how much credit you have available, what your monthly debts are, and other types of information that potential lenders will consider to determine whether you are a good candidate to loan money to. The report itself does not include your credit score. Your score is based on formulas that use all the information in your credit report boiled down to a simple number. Credit Bureaus, also known as credit reporting agencies (CRAs), collect this information from merchants, landlords, lenders, etc., and then sell your report to businesses so they can evaluate your report for credit.
There are three major credit bureaus that collect your information, Equifax, Experian, and TransUnion. Along side these there are over 1,000 local and regional CRAs typically affiliated with these three. These CRAs are collection agencies for information about customers. Here’s a quick example of how they work. Let’s say you apply for a credit card and provide the card company with your personal information such as name, address, employer, and other credit cards you have. The card company then contacts one of these CRAs and reviews your credit report. If the card company approves your request for a card, then the information you supplied is forwarded to the credit bureaus along with your new terms for your card.
Here is a list of information that makes up your credit report:
Personal Identification Information: Information such as name, address, social security number, birthday, telephone number, and previous employers
Credit History: This includes your bill-paying history with banks, retail stores, finance and mortgage companies, and others who have granted you credit. Information about each account you have, such as when it was opened, what type of account it is, how much credit it includes, and how much your monthly payment is, is included. Closed accounts and paid off loans will still appear as well as late or missed payments.
Public Records: Information that might indicate your credit worthiness, such as tax liens, court judgments and bankruptcies.
Report Inquiries: This section includes all credit grantors who have received a copy of your credit report along side any others who were authorized to view it. In addition, lists of companies that have received your name and address in order to offer you credit are included. These companies don’t actually see your report, but get your name if you meet their criteria for an offer of credit, insurance or other product. This is where all of those “pre-approved” credit card offers come from.
Dispute statements – The report may also include any statements you’ve made disputing information on the report. These statements will not affect your score directly, unless they have been approved to remove false information. Most credit bureaus allow both the consumer and the creditor to make statements to report what happened if there is a dispute about something on the report.
Things such as bank account balances, income, and driving records do not appear on your report.
Lenders look at many different things when they want to determine whether you will be a good credit risk or a bad credit risk. Some things that might seem innocent to you are sometimes the complete opposite to lenders. For example, if a lender sees that you have inquired about your credit multiple times, or opened multiple new credit lines, they will shy away from lending to you because they will assume you are about to take on a large amount of debt. Missed payments are also a red flag for obvious reasons, and these stay on your report for 7 years! Maxed-out credit lines could imply that you are financially strapped. Experts say that if you have a maxed-out line you should consider moving some of that debt around.
There are several scoring methods, but most lenders use the FICO method from Fair Isaac Corporation. Each of the three major credit bureaus listed above worked with Fair Isaac in the early 1980s to come up with this scoring method. Your credit score is determined by a specific weight value set for each piece of information appearing on your credit report. Much like how a teacher determines your grade for a course by deciding your average value of your test scores, quiz scores, homework grades, and participation to come up with a single number score. A credit score will range from 300 – 850. The exact formula for calculating your score is proprietary information owned by Fair Isaac, but here is an approximate breakdown of how it is determined.
35% of your score is based on payment history. Sensibly having the most importance; lenders want to know when you pay your bills (on time, late, or at all). The score is affected by the amount of bills paid late, and how many were sent out for collection or bankruptcies. The time frame of these also comes into play, with the more recent negative occurrences lowing your score the most.
30% of the score is based on outstanding debt. How much you owe on a car or loan and how many maxed-out lines of credit you have. The more cards and lines of credit you have maxed-out the lower your score will be. A good rule to follow is try and keep your card balances at 25% or less of the maximum balance for the best credit impact.
15% of your score is based on how long you’ve had credit. The longer you have an established credit score the better your score will be. The more information of your past credit gives lenders better advice on how to predict your future credit.
10% of the score is based on new credit. New credit accounts will negatively affect your credit for a short period of time. This category also penalizes hard inquiries on your credit in the past year; those you’ve given permission to view when you are shopping for a large loan for a house or a car, as opposed to soft inquiries, which include looking at your own score, or companies trying to pre-approve you for their credit card programs, have no effect on the score. However, the score interprets several hard inquiries within a short amount of time (between 1-3 weeks) as one inquiry to account for the way people shop around for the best deals on a loan.
10% of the score is based on the types of credit you have. Having a variety of credit shows lenders that you can manage and maintain multiple balances.
Improving your Credit
Credit scores are not set in stone. Your score will fluctuate as your credit report changes. Although some changes will be minor, others can be much more dramatic. Here are some things financial experts recommend to maintain or increase your credit score.
Review your credit report and correct any errors. A shocking percentage of credit reports contain errors; one study done says that almost 25% of reports fall into this category. Annually looking over your report and filing to correct errors you find can dramatically fix your score.
Keep old credit accounts, even if you’re not using them. Creditors look at debt-to-credit limit ratio and the average age of your accounts using this information to predict your credit patterns in the future. One of the biggest mistakes you could make is closing down one of your oldest credit lines. Even if you do not use it anymore, it is important to keep these lines because they have the most history attached to them.
Reduce your credit card debt to under 75% of your available credit. A lower debt-to-credit ratio will increase your score, due to the fact that you have room to take on more debt, but you show you are financially responsible enough to manage a set amount.
Pay your bills on time. Paying your bills when they’re due, or even early, is a great way to improve your score provided that there are no major errors on your report already. You may not see a dramatic increase in your score right away, but over time this will definitely pay off.
Do not let anyone run your credit unless they absolutely have to. The more inquires on your report the lower your score usually is. When you are shopping around for a loan make sure you run your credit within a few weeks of each other so it only counts towards your report as one inquiry.
Do not open multiple lines of credit at once thinking this will improve your score. Opening new lines of credit will have a negative impact for a short term. Lenders will think that you are planning to take on a lot of debt and will not want to loan you money. Although, over longer periods of time, the more credit you have available the better your score will be.
Don’t wait! You can start using all these methods to start increasing your credit score today. The more you manage your finances, the more opportunities you will see in the future to save you money. When you apply to purchase a vehicle or mortgage, your credit score will define what you will be paying in interest. The higher you score, the lower your interest rate which means more money in your pocket. If you are considering purchasing a vehicle, but are unsure if you qualify, use our instant credit approval tool below. You can input your information directly onto the form, or simply click “autofill through Facebook,” this tool will not affect your credit score, and there’s no SSN required!
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