Credit reports are merely a record of your transaction history with no analysis. A credit score is similar to a cumulative GPA at college. It’s a collection of numbers that analyzes your performance relative to other individuals, assigning you a specific grade.
Your credit score is one of the most critical numbers in your life. Its importance is no less than a bank account balance or social security number. Creditors and mortgage lenders will assess your credit score and accept or decline your application based on the score and accompanying report.
The article below explains how credit scores are calculated, how to maintain a good credit score, and how to avoid a bad credit score. Let’s first start with understanding exactly what your credit score is.
Understanding Your Credit Score
A credit score helps lenders decide on the terms of a loan and whether the individual’s financial history indicates timely payments. Your personal credit score is derived from your credit history. Credit scores typically range from 300 to 850. Three leading companies compile credit scores of different borrowers: Equifax, Experian, and TransUnion.
A good credit score is essential for financial stability, as it indicates the ability of an individual to pay off their obligations. A higher credit score indicates less financial risk. There are two broad categories of credit scores: generic and custom.
Generic credit scores are used by most lenders and companies to determine financial risk. Custom credit scores, on the other hand, are tailored for a specific type of lenders. Auto and mortgage lenders are two examples of users that may require custom credit scores.
Credit scores are three-digit numbers. The lower end of the spectrum, 300, indicates the lowest score, while 850 is the highest score achievable.
Different models of calculating a credit score may use a different range. However, a higher score is always an indicator of financial stability and creditworthiness.
Here are some breakdowns of each credit score range:
- 750 to 850: Excellent
- 700 to 749: Good
- 650 to 699: Fair
- 550 to 649: Poor
- 350 to 549: Bad
A higher score indicates a substantial likelihood of managing and paying off previous credit promptly. It’s an indicator of timely payments and well-managed balances.
A lower score denotes poor handling of prior credit. It also indicates things like high credit card borrowing, taking on more than you can handle, missed or late payments, and even the possibility of foreclosure.
A low credit score makes it harder to get access to loans and credit cards. Even if you are approved, the interest rates offered are much higher.
How Credit Scores Are Calculated
FICO is the most commonly used measure by lenders to determine the creditworthiness of loan applicants. Developed by the credit bureau FICO, this score uses five components to arrive at the final credit score.
Payment history (35%)
Payment history looks at the timely payment of your credit accounts and whether they were consistent enough. It considers any bankruptcies, collections, and neglect. These problems, the time taken to resolve the issues, and the period since they last took place all contribute towards the final calculation.
Amount owed (30%)
The second most significant factor in your credit score is the amount you have borrowed relative to what you can borrow. Credit scoring methodologies identify borrowers who are a financial risk. Such borrowers spend up to or beyond their credit limit. Lenders see the optimal credit utilization as at or below 20%. Credit utilization is an indicator of credit expressed as a percentage of credit available. Massive debt from various sources also hurts this calculation; thus, lowering your score.
Length of credit history (15%)
The longer a borrower has had credit with timely payments, the more financially stable they appear. For instance, a person with a credit account for 20 years with no late payments will have a higher score assigned as compared to a person who has had credit for 2 years with timely payments.
Types of credit accounts (10%)
Having a mix of different credit accounts, such as a mortgage loan and a business loan, is a good indicator for this factor.
New credit (10%)
When borrowers apply for loans too frequently, it is an indicator of financial instability. It implies that each time you apply for credit, it affects your score.
Common Myths About Your Credit Score
Your credit score only analyzes information within the credit report and doesn’t include or consider additional data that some lenders may require. Credit score doesn’t consider factors such as length of employment and salary.
Your current job and income have no direct impact on your credit score. A credit score usually doesn’t include employment status.
But your employment status and salary do affect your credit score, as you still have to pay off any credit you may have. Applications for credit approval do require income and job status.
People might be led to believe that closing a credit card account will improve the score. In reality, it is quite the opposite where closing the card usually leads to an adverse effect on your score.
Most credit scoring formulations consider credit utilization. By closing an unused line of credit, you are diminishing the credit available to you. This increases the credit utilization, and lenders prefer lower percentages of this ratio.
In all honesty, I don’t believe in “credit repair companies.” Bad credit scores can only be repaired through measures taken on an individual level.
Credit reestablishing services may come up with a feasible plan to manage your debts better, but the right way of improving your credit score is to manage your credit well.
Understanding Your Credit Report
Your credit report is an accumulation of your credit transactions. It’s information that lenders who give credit to you provide to credit reporting agencies.
he information within the credit report is used to compile and calculate an individual’s credit score. Your credit report contains information on the type of credit utilized by you, the timeline of different loans, and whether you have been prompt in your payments.
It shows lending agencies how much credit an individual has used and if they are looking for new sources to acquire credit. A credit report gives a more comprehensive view on credit history than other transactional sources such as banking reports.
There are three leading credit reporting agencies: Equifax, TransUnion, and Experian. These companies provide credit reports to different sources such as lenders, creditors, insurers, and various other businesses authorized to view the credit report under the law.
The process starts when an applicant applies for a new source of credit (like a mortgage). The lender then requests a credit report from either one or multiple credit agencies.
The lender analyzes your credit report in junction with other factors such as credit score, income, and other data provided by the applicant. Based on this evaluation, the lender approves or rejects the application and sets up the timeline and interest rate (if accepted).
Once an application is approved, it will be included in the credit report as a new source of credit and will be updated every month. Credit lending agencies such as banks, financial institutions, and credit card providers send monthly updates to the credit reporting companies.
Breaking Down the Credit Report
Credit reports mostly comprise of 6 sections:
The identification part on the credit report generally includes name, social security number, birth date, address, and phone number.
This is included in the personal information part and acts as an identity guarantee.
This section lists any statements you have provided to the credit agency. For example, if you requested to change any information within the report and it was not changed, then your consumer statements will convey your reservation about the information and explain your viewpoint.
This section mostly contains banking account statuses and details. Open accounts, closed accounts, payment timelines, credit utilization, current account, savings account, and loan payments are all examples of information you can expect to see in this section. Timely payment of bills and rent are also present in this section. Late payments hurt credit reports for up to 7 years before removal.
Your history as a citizen is included in this section. Cases, judgments, and arrests are all included in this section including bankruptcies, foreclosures, and repossessions of your car or assets.
Hard inquiries can hurt your credit score and credit report. They occur when a lending agency checks details of your credit history, and you must provide authorization. It can also happen when someone requests for a line of credit using your name. Unauthorized hard inquiries are an indicator of someone using your identity for credit.
How to Get Your Credit Report
A credit report is one of the most important documents relating to your finances. It’s vital to check your credit report at least annually to make sustainable financial decisions.
The Fair and Accurate Credit Transactions Act (FACTA) established in 2003 has granted individuals access to get a free credit report. FACTA entitles you to receive one free copy of your credit report from the major nationwide credit reporting bureaus: Experian, Equifax, and TransUnion.
Any person with some awareness of such matters should take advantage of the FACTA to view their credit report and analyze their credit history at least annually.
There are three ways to get the free credit report annually, as specified by the FACTA:
- First, you can get it online through annualcreditreport.com
- You can get it via telephone
- You can also have it mailed via a request form
There are alternate ways for you to receive a free credit report as well. Several sites offer a free credit report, and they do not require you to pay as they make money from advertising. Registration and receiving a report is free on these following websites:
Besides the free annual report you are entitled to, certain conditions make it possible to obtain a free credit report. These requirements and circumstances are as followed.
- An application for credit was denied based on your credit report. Such applications include credit cards, insurance, and mortgage applications. From the date of the denial, you have 60 days to request a free copy of the credit report. The lending agency generally includes the contact details of the credit agency that provided them with the credit report.
- You received state welfare.
- You are unemployed and intend on applying for a position within 2 months (60 days).
- Your credit report contains inaccurate information due to potential identity theft.
Removing Negative Items
Upon viewing your credit report, you will notice a part devoted to negative items. These unfavorable items tick off potential lenders and might be the basis for a loan rejection or higher interest rate payments.
Such things include, but are not limited to, unpaid bills, late payments, and outstanding debt.
Common negative items in the report are:
- Collections Accounts: Taken down seven years after the initial neglect
- Delayed Payments: Taken down seven years after the initial late payment
- Bankruptcy: Taken down seven to ten years
It’s vital that you pay whatever credit you have borrowed.
However, there are strategies you can deploy to remove negative items off your credit report.
Searching for Errors and Disputing Them
Do your due diligence on your credit report and make sure there are no mistakes within the negative section.
Such mistakes include accounts you are not aware of (possibly due to identity theft), negative items past their drop-off period, personal information error, and accounts closed off but still listed as unpaid.
After the discovery of an error, the first step to be taken is to notify the creditor. They are required by law to investigate the negative item and respond back within a month.
If they agree with your statement and realize the error, they notify the three main credit bureaus to fix your report.
If your dispute doesn’t reach a desirable outcome, then an individual can request their dispute statement to be included in future credit reports.
Negative Items That Are Not Errors
Sometimes, you have to make ends meet and might not be able to pay a bill or it went late for some reason. For late payments, you can write a goodwill letter. A goodwill letter is sent to lenders requesting them to remove a negative item from your credit report.
Creditors do not have to remove correct information from your credit report unless it is inaccurate. If an individual has been timely with their payments and the late payments are just one-off instances, then some lenders do remove negative information such as a late payment.
They do this by not updating it in their monthly credit report sent to the credit bureaus. This is only the case when your credit history is rated as good, and the incident was isolated.
How to Reduce High Credit Utilization
There are often mixed views on how much credit utilization is optimal for a good score. Some say its 20% while others say it is below 30%. However, if you are above this range, there are strategies you can deploy to reduce your utilization rate for a better credit report and a better credit score.
Pay down debt
A combination of paying more than the minimum each month and reducing outstanding credit card balance could do wonder for your credit. Even small additional payments on your credit cards through the course of a month can increase debt payoff and keep your credit utilization ratio in check.
Reduce your spending
If you are struggling to pay off partial or full payment on your credit cards, it would be wise to stop using them for buying more things. Switching to a debit card or cash would be a better option. Otherwise, your credit card debt won’t budge, leaving you with a high credit utilization rate.
Increasing the credit limit
By increasing the amount of credit available to use, you can effectively lower the credit utilization rate. You can raise the limit of your current credit cards by putting in a request. Certain factors credit card issuers look at before increasing your limit. These include how long you have been their card holder and late payment history.
Unused cards should not be closed
One way of reducing the desire to spend is by closing any unused cards as it’s a line of credit available to you. However, doing so reduces the credit available to you and actually increases your credit utilization rate.
Using personal loans to pay off credit card debt
Taking out a personal loan to pay off credit card debt can be advantageous. Assimilating different credit card balances into one loan leads to a reduced interest rate. Also, it is easier to pay off a lump sum amount owed to a single creditor rather than paying off multiple credit card balances.
Disputing with Credit Bureaus
Checking your credit report for errors, negative items, and discrepancies is something everyone should do at least annually. It can significantly affect your ability to get credit and the cost of that credit.
The Fair Credit Billing Act (FCBA) authorizes consumers to dispute any information they believe is inaccurate or erroneous.
The three major credit bureaus have to act on any request sent to them and have 30 days to certify the information with the lender, bank or collection agency. They are obligated by the law to do this and provide results to the person contesting the dispute.
You can even dispute a legitimate account because the creditor must certify and prove your ownership of the account. Otherwise, the credit reporting companies must remove it. If the credit bureau suspects that you are disputing accurate items on purpose, the dispute will be marked as such.
There are several ways through which you can file for a dispute with the credit bureau.
You can do it by mail, phone or online and can deal directly with this credit reporting agency. If this disputed item doesn’t get removed, there is a 4-month cool-down period after which you can dispute it again.
What Is a Personal Statement?
Credit bureaus allow for the inclusion of a 100-word personal statement that will enable you to provide any additional information concerning the items on your credit report.
The statement can be regarding any part of your credit report. Following listed are examples of why people commonly write statements.
Clarifying a bankruptcy filing
If you can explain your bankruptcy reason to let lenders know about your situation, it may improve the prospects of obtaining a loan or a credit line. Unexpected tragedies such as going through a tumultuous divorce or a significant medical issue may help in clarifying your situation.
Clarifying inaccurate information
Oversights and mistakes in your credit report not being updated can be clarified and explained from your perspective.
Clarifying a dispute
If you are currently in the process of removing any unauthorized hard inquiries or credit access resulting from identity theft, you can mention you are working towards having it removed.
Specifying a negative item
If you have late payments or missed bills on your report, you can try to clarify the scenario, although it won’t affect your score.
A note to mention is personal statements in your credit report not bringing benefits of any kind usually. Many lenders do not take the time out to read them or might use a computer program to analyze your credit report.
Tips for Building Excellent Credit
Bad credit history could deprive you of many opportunities in life such as your first home, education funding or even getting a job. It’s therefore essential you build and maintain good credit from the get-go. Listed below are tips that can help you build good credit.
Bite Off Only As Much as You Can Chew
People often confuse spending on a credit card with having spent their own money. This is a fast way of ending up with a lot of debt. The most optimal way of building good credit is to use only your credit cards for what you can pay off.
This habit is not just good for your personal credit report and score, it also relays to potential lenders you are a disciplined borrower. This will improve your chances of getting a loan and future financing on better terms and interest rates. It also keeps excessive spending and debt at bay.
Use Only the Credit You Have
Utilizing your credit cards to their max or close to their maximum limit affects your credit utilization rate and creates a bad credit report and score.
This is especially true if you don’t plan on or have the means to pay off outstanding credit card debt within a month. Credit lenders know users who max out their cards have trouble paying back what they owe.
Use a Single Card
The feeling of spending what doesn’t belong to you encourages first-time users to assimilate different credit cards. The more cards you have, the more debt you have to keep track off and pay off.
Hard inquiries are common for people applying for too many cards. Several inquiries in a specific time frame, with new cards, can hurt your score. Credit inquiries account for 10% of your credit score so remember that before applying for a new card too early.
Pay Off Your Outstanding Balance in Full
By charging only what you can afford to pay, you also ensure that you can meet your payments in full each month.
Paying off what you owe each month diligently proves you are financially stable and disciplined. A large part of your credit score also consists of timely payments of the bill. So you are laying the foundation of a good credit score.
Pay All Your Bills on Time
All bills and payments are not part of your credit report, but late payments can wind up on the credit report. If you neglect any payment and the credit account is sent to a third party for collection, it is counted as delinquency and poses as a negative on the credit report.
How to Maintain Credit Once It’s There
There are many advantages of maintaining a good credit score such as better terms for loans and mortgages. Using credit wisely and managing it responsibly is the key to maintaining a good credit score.
Knowing the Stuff That Effects Your Credit Score
Knowledge is power. This adage holds true for credit scores. If you know the components that make up your credit score, then you can maintain a good score from the start.
Punctual Payment of All Bills
This holds true for all bills and not just credit card dues or loans. Some bills are not on the credit report for being paid on time. However, they do wind up there if you are late or miss a payment.
Limiting New Credit Lines
Hard inquiries into a new application for credit, such as credit card or personal loans, affect your credit score.
Avoiding Major Credit Pitfalls
Every credit step you take from getting your first credit card will determine whether you fall in the category of bad credit or good credit. Simple choices can help an individual avoid the lousy credit road.
Think Twice Before Spending
Every new expense is an opportunity cost forgone and could have been used to pay off outstanding debt. We often spend on things we don’t even need. When you are making ends meet and are stacked up high in debt, it would be wise to cut out expenditures on wants and focus only on the necessities.
Staying out of the Debt Cycle
When revenue is tight, and the expenses are piling up, using a credit card might be tempting and alluring. But don’t make that mistake. Using a credit card to pay off expenses you cannot afford is a sign you cannot make payment within the month. You will then incur interest expense on your credit card debt which will leave you in a worse off scenario.
Taking on Excessive Debt
Level of debt is the second largest component used in calculating the credit score. The level of debt impacts your ability to pay off what you owe. Identify and stop before gathering too much debt. Not only would it affect your punctuality, but could lead to foreclosures and repossessions if non-payment occurs.
Whew. Well, there you have it. How to build credit.
We went through the entire history and makeup of your credit, and even gave you some tips on how to fix problems, build good credit, and keep it there.
The question for you is – what will you do to as your first actionable step now that you’ve read this whole article?