Understanding Credit

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Credit. When it comes to understanding personal finance, this component looms large. For some it is a dirty word, to be avoided at all costs. For others, it is an intoxicating license, an opportunity to reach for a lifestyle well beyond their means.

In truth, credit can be extremely helpful or harmful depending on how it’s used. In many ways, credit is more of a tool than anything else – simply a means of achieving some desired outcome. In the hands of an uneducated, unskilled, and inexperienced person, a fire, a table saw, or a gun can cause havoc and harm. But in the hands of a responsible and educated individual, they can be immensely useful. So it is with credit.

A bad use of credit would be buying a huge flatscreen television with a credit card; you’ll receive little return on the interest you’ll pay on that balance. A good use of credit would be taking out loans to get an education, or for a car to get you to and from a job; these things put you in debt in the short-term, but will improve your financial prospects in the long-term.

When you need to use credit in a positive way, your ability to do so will be based on the credit history and score you have been establishing for years, starting when you first headed out on your own.

What Is Credit?

As the dictionary defines it, credit is: “The ability to obtain goods or services before payment, based on the trust that payment will be made in the future.” Student loans, car loans, home mortgages, and credit cards are all types of consumer credit instruments — you’re getting money now to pay for something you otherwise couldn’t afford, based on the lender trusting that you’ll pay them back later.

Sometimes credit is completely free, but it usually comes at a price. Most banks and institutions will charge interest on the money they lend you (aka, the principle) in exchange for giving you the funds, along with the opportunity to pay it back slowly over an extended period of time.

Different types of credit have different interest rates. Student loans often have lower interest rates than other types because many of them are guaranteed by the U.S. government. Even if you can’t pay them back, the lender will still get their money from the government. Credit cards, on the other hand, often have the highest interest rates among the various types of credit because: 1) there’s a higher risk that the credit card lender won’t get repaid and 2) it’s more expensive to manage credit card debt (at least that’s what the credit card companies say).

Even among the same kinds of loans, you’ll find different interest rates. That’s because people have varying degrees of “creditworthiness”. You’ll often hear banks refer to people as having “good credit,” bad credit,” or “no credit.” People with good credit have a reputation for being a responsible borrower. They pay their bills on time and manage the credit available to them responsibly. People with good credit not only have access to more money, they also get lower interest rates on their loans.

People with bad credit have a reputation for not paying their bills on time or even not paying them at all. Banks and other businesses are less willing to extend credit to these individuals. Even if they’re able to get a loan, a person with bad credit will be charged a higher interest rate.

Folks with no credit simply don’t have a history of using credit, so they’re kind of a wild card. They might be good with credit, or they might not. When banks loan money to people in this situation, they’ll usually start off charging a higher interest rate, but they’ll be willing to bring it down as the debtor demonstrates they can repay the balance owed on a consistent basis.

How Do Banks Know If You’re Creditworthy?

So how do banks or credit card companies know whether you have good credit, bad credit, or no credit? When you apply for a loan, the person reviewing the application probably doesn’t know you from Adam. How can they possibly discern whether or not they can trust you to pay them back?

Put on your tin foil hat folks, because the answer is that there are three big credit agencies keeping track of how you use credit — from how much you borrow to how often you are late on payments.

You’ve probably seen the commercials on TV about how to get your hands on a free credit report. That’s the record those Big Brother-like agencies have on you. These commercials will also typically mention something called a credit score. That’s the number that banks use to indicate whether you’re a trustworthy borrower or not.

Many young people just getting their feet wet in the world of credit often confuse credit reports with credit scores, and vice versa. It’s an easy mistake to make, but one that can be corrected with a quick primer on the difference between the two.

What’s a Credit Report?

Credit reports explain what you do with your credit. They state when and where you applied for credit, whom you borrowed money from, and whom you still owe. Your credit report also tells if you’ve paid off a debt and if you make monthly payments on time.

Federal law mandates that all three major credit reporting agencies must each give you a free credit report each year. So, when those TV commercials talk about getting a free credit report, the above information is what they’re offering.

But, getting your free credit report from a heavily-advertised site like FreeCreditReport.com or FreeCreditScore.com isn’t a good idea. In return for getting a free credit report and score, you have to enroll in their monthly credit-monitoring service for $15 a month. If you cancel within seven days, the report and score are indeed free, but if not, your subscription to their service will begin. The pain is that you have to call to cancel — you can’t do it online — and you might forget (that’s what they’re counting on).

Instead, get your free credit report with no strings attached from AnnualCreditReport.com. This site offers you a truly free report from each of the three credit agencies. You can get them all at once, but I would recommend staggering them throughout the year so you can keep more regular tabs on your credit score.

Why You Need to Request Your Credit Report Every Year

There are a couple of reasons why you should request a free credit report each year. First, it allows you to check for and correct mistakes that have crept into your report. You don’t want those mistakes to affect whether you get a higher or lower interest rate, or whether a bank will approve a loan for you at all. When you spot a mistake, you can start taking actions to clean it up.

The second big reason you want to request a credit report every year is to protect yourself from identity theft. With the right information, a con-artist can apply for a wallet full of credit cards in your name without you knowing it. Then you start getting calls out of the blue from collection agencies asking you to pay up on purchases you never made. A yearly credit report lets you check to see if anybody is fraudulently using your name to apply for credit cards or loans without your knowledge and take action if needed.

What’s a Credit Score?

Your credit score is determined by the information in your credit report. Credit scores are used by companies and banks to evaluate the potential risk posed by lending money to individual consumers. Your credit score determines if you qualify for a loan, what your loan’s interest rate will be, and what your credit limit is. It’s basically your trustworthiness score for lenders.

The company that came up with the idea of a credit score was the Fair Isaac Corporation. That’s why you’ve probably heard credit scores referred to as a FICO score. Because each of the three credit agencies collect slightly different information about you, you’ll have three different credit scores, although it’s possible for all of them to be the same.

Credit scores range from 500 to 850. If you have a FICO score of 500, you’re going to have a hard time getting a loan. Even if you manage to get one, the interest rate on it will be high. With any score above 720, you’ll receive the best rates available. Whenever you apply for a credit card or car loan, banks and credit card companies will check your credit score to determine whether to lend you money or extend the credit card to you in the first place. If they do decide to extend you credit, they’ll then use your credit score to determine the interest rate they’ll charge you for borrowing money.

Unlike credit reports, which are free, credit scores cost money to view. They cost about $15 to access, and you’re given the offer to purchase your credit score after you get a credit report. Bankrate, however, offers a free FICO score estimator. The estimator asks you 10 questions about your loans and credit card balances and then spits out an estimate of your credit score. While not 100% accurate, you’ll at least have an idea of where your score is at and make adjustments in order to improve it.

How Your Credit Score is Determined

Because your credit score can possibly make or break some important financial and lifestyle decisions, it’s important to understand how the credit agencies determine your score so you can take actions to ensure it’s the best it can be.

When coming up with your FICO score, credit reporting companies look at several factors, including:

Payment record. 35% of your score depends on your ability to pay your bills on time. Payments that are more than 90 days late will hurt more than a payment that’s just 30 days late. Also, recent late payments hurt more than older ones. A single late payment won’t kill your score, so don’t panic that you’ll never be creditworthy because you missed a payment. Just pay the bill and try not to let it happen again.

Amount borrowed relative to available credit. This factor accounts for 30% of your score. The credit companies want to know if you’re borrowing to the max. If you have $10,000 of available credit, and you consistently run a balance of $9,999, that’s a red flag that you’re not very prudent about your debt. However, if you usually have a balance of $200 of outstanding debt, that’s a sign you’re more responsible with credit. To improve your score, try to keep your debt to about 10% or less of your available credit.

Length of credit history. This is 15% of your score. The longer you have successfully borrowed money and paid it back, the less risk you are to a lender. If you pay off a credit card, it’s good to keep it open, even if you never use it. When you close it, you lose that credit history, which could in turn affect your score.

“Hard” Credit Pulls. This is 10% of your credit score. A pull is a type of inquiry into your credit. Hard credit inquiries are made by lenders for the purpose of extending you credit. These will lower your score because having multiple hard inquiries is a signal that you’re looking for loans and are possibly a poor credit risk. So, when the cashier asks if you want to sign-up for a store credit card to get a 10% discount, tell them “no thanks” in order to avoid the hard credit pull.

If you’re shopping around for a car loan or mortgage, lenders will have to pull your credit score every time you ask for a quote. Don’t worry about those types of pulls hurting your score. Similar inquiries made within a two-week period won’t ding your score.

Types of debt. This is the final 10% of your score. It’s best to have a mix of car, home, student loans, and little to no credit card debt. If you’re up to your eyeballs in credit card debt, you’ll be seen as bigger risk.

Other factors. In addition to your FICO score, lenders will also to take into account other factors when determining whether to loan you money. Things like your income, job history, and assets you own can factor into whether you can secure a loan.

How Can I Build and Improve My Credit History and Score?

Because your payment record and length of credit history make up about 50% of your credit score, it’s important you begin building a solid credit history as soon as you can. A good credit history along with a high credit score will serve you well later in life.

The fastest and surest way to build up your credit history is to simply open up credit accounts and pay back the money when it’s due. Opening a credit card account is an easy way for young people to begin establishing their credit history.  A low interest, low minimum balance credit card can give a young person just starting out in life the opportunity to pay a credit balance on a regular basis in order to establish a solid positive payment record. Also, the earlier a young person obtains a credit card, the longer his credit history will be when he applies for that mortgage later in life.

There is a danger, though. Credit cards can be a big time hazard for a young man just starting out on their own, as they allow you to spend money you don’t have. And because a young man’s schedule can be hectic and his life disorganized, he may forget to pay the monthly balance, incurring penalties and interest, and potentially plunging him into debt. If you don’t have the income and level of responsibility to pay off your credit card balance every single month, don’t get a credit card.

Even if you are responsible enough to get a credit card, maybe you just don’t like the idea of having one and want to avoid credit card debt altogether during your younger years. Smart move.

So what if, for whatever reason, you want to avoid getting a credit card, is there any way to still build up your credit history or are you doomed to high interest rates when you apply for a mortgage later on?

Despite what some people may tell you, it is possible to establish a credit history and improve your credit score without a credit card. If you’re a college student, you likely have student loans. As soon as you graduate, start paying your loans back on a consistent basis. Boom. You’ve got a credit history.

Another way to establish your history without a credit card is to apply for a small loan through your bank and have your parents co-sign on it. Make regular payments and pay it off as fast as you can. More credit history.

But let’s say you’re a complete Dave Ramsey devotee and decide to not use credit at all: no credit cards, no student loans, no car loans. Nothing. How can you secure a low interest rate when you’re ready to buy a house if you don’t have any credit history (assuming you haven’t reached the Ramsey pinnacle and are able to buy a house in full with cash!)?

By applying for a PRBC Alternative Credit Score. A PRBC Credit Score shows lenders you’re financially responsible and trustworthy by keeping track of how well you pay non-credit bills like rent, utilities, and insurance on a regular basis. It’s relatively new, but many lenders will accept a PRBC Alternative Credit Score when determining interest rates for mortgages and other loans.  Unlike your traditional credit history or scores that begin tallying as soon as you use credit, you’ll need to self-enroll to obtain a PRBC Alternative Credit Score.

Any other things a person heading out on their own for the first time needs to know about credit? Share them with us in the comments!